Stocks rose yesterday for the third straight day. Combined the three sessions came close to wiping out Monday’s losses. But futures this morning are pointed lower again, and stocks are on course for their fourth straight weekly decline. After a straight-line increase of 25%, a 5% correction isn’t particularly worrisome. Of course, if it escalated into something much larger, that would be concerning but there simply doesn’t seem to be either internal momentum or external influences that are visible that would be catalysts for a major market move in either direction.
As often happens when stocks churn sideways, there are cross currents at work. On the plus side, earnings were a bit better than expected in the first quarter and appear likely to grow somewhat faster over the balance of 2019. Second, interest rates have fallen, and that translates into higher P/E ratios for the market overall. On the negative side, higher tariffs and the lack of a trade deal with China surprised investors who thought the two countries were on a path toward a treaty of some sort. On the other hand, Trump has delayed any action on auto tariffs and is discussing the elimination of aluminum and steel tariffs on products imported from Mexico and Canada assuming the three-way trade deal gets approved by all. Also, on the negative side, there are indications that Q2 growth in the U.S. will be less than it was in Q1. Estimates now center around 2%.
Against this backdrop, markets have increasingly priced in, via Fed Funds futures, a likely rate cut this fall. That may be an inaccurate prediction even acknowledging that the short end of the yield curve (under 5 years) has inverted once again. Notably, at the same time, the long end of the curve, from 2-10 years, has steepened slightly. I take this to mean that markets are not forecasting recession but believe that short rates might be a bit too high. While there may be truth in that judgment, I think the Fed will have to think hard about cutting rates, barring a jarring external event, unless growth stays materially below 2% for more than one quarter, or inflation falls below 1%. In a low rate, low inflation world, the Fed has only so many tools available to fight the next recession. Cutting rates now would use some of its fire power. While some in Washington suggest that growth of 3% or more could be sustained if the Fed were more accommodative, that may or may not be true. Moreover, if growth is going to slow in the months ahead, no doubt one of the principal causes will be the increased use of tariffs. Tariffs are a tax. They are monies that importers (American companies) pay to the government. It’s illogical, on one hand, to increase taxes; then, on the other hand, ask your central bank to add more money to the market to restore the growth taken away.
Back to China, I think we should all look at recent events within a lens that looks out years. There is little doubt that, economically, China is going to be the United States’ largest competitor for many years to come barring some sort of political upheaval. And that competition will only intensify as China grows. To date, China, on the world stage, has succeeded mostly by being a low-cost producer of goods sold for export. Its goal, however, is to climb the value chain and, ultimately, be a world frontrunner in leading edge products for tomorrow. This is essentially the same model successfully employed by Japan and Korea. Japan, after World War II, became the major low-cost producer but, over time enjoyed leadership positions in such branded products like Sony televisions or Toyota automobiles. It also became the world’s leading producer of semiconductors and steel. To a lesser extent Korea followed the same path with names like Samsung, Hyundai, and LG. China hasn’t reached that stage yet but is trying to catch up. It is not beyond taking short cuts, and that includes the theft of intellectual property and forced technology transfers. Trade negotiations are trying to make the Chinese play by world rules. Since at the moment, it has little intellectual property worth protecting, the Chinese are reticent to stop stealing. Someday, when its own intellectual property has real value, it will. But probably not today.
But it isn’t so simple for the Chinese. It faces a multitude of problems. First, its population is starting to age, and its work force population is about to start declining. Second, as China’s per capital GDP has risen, it isn’t any longer the low-cost producer, particularly for goods of relatively low value that are produced with high labor content. Think golf shirts, for instance. At the same time, with the U.S. government focused on the escalating economic competition between the two countries, tariffs and other tools that are attempts to either level the playing field or give us an advantage, aren’t just a 2019 event.
American companies can look at China in two ways. First and foremost, China is a huge market that presents an enormous opportunity. Population wise it is the largest country on the planet. And it has the second highest GDP. American companies want to sell into China. While China may block some, like Google# and Facebook#, it welcomes others, like McDonald’s#, Coke# and Starbucks. The latter three sell in China, produce in China, and source in China for products sold there. They are not directly impacted by tariffs, although they would be hurt if tariffs slowed the Chinese economy. The other way to look at China is what I alluded to before, as a low-cost manufacturing source for goods to be sold here. For these companies, the existing supply chain, sourcing product and manufacturing in China, to supply the U.S., is now highly suspect. To the extent that manufacturing can be relocated to other countries, like Vietnam or Indonesia, it will. Before tariffs there had been some movement in that direction anyway given that China has ceded its low-cost leadership over the years. Tariffs simply accelerate the move. Some manufacturing could even return to the U.S., particularly if production could be automated and labor content kept to a minimum. At the national level, this is exactly what President Trump wants to achieve.
Changing supply chains don’t happen overnight. It is going to take a bit of time for China to realize that (1) heightened competition is sure to attract more government attention over the next several years, and (2) unless and until China wants to play by world rules, we will have to level the playing field in other ways. Tariffs aren’t the only way but they will serve to accelerate the movement of manufacturing out of China. As that movement accelerates, China will have to reexamine how it chooses to compete. If, for instance, it reduces theft of intellectual property and tariffs are reduced, the pace of manufacturing losses to other nations could be reduced. Said rather simply, the game today is really in China’s court. If it insists on playing the economic game as it has for the past many years, it will have to accept tariffs as a higher cost. I don’t think Mr. Trump has to be quick to add more tariffs or to raise the levels. He may be better served holding onto the threat, particularly since raising tariffs on consumer goods imported from China, like iPhones, will carry with it a much more significant economic cost back home.
Some suggest China may wait out the 2020 elections hoping Trump loses. That may be a very bad strategy. First, if Trump wins, he no longer would carry personal political risk post the election. Second, should a Democrat win, simply eliminating the tariffs in place without any Chinese concession would be a very weak position to take and would be subject to much criticism. Third, over the next two years, China would be risking an accelerating loss of manufacturing to other Asian nations as foreign companies adjust supply chains.
Our economy can easily tolerate the tariffs now in place. China is likely to feel more pain. That means we have the greater leverage. If there is no treaty, and everything stays as it is today, the most likely outcome will be an acceleration of moves to change supply chains. Such a move would lower costs for American importers and reduce manufacturing output in China. Thus, the economic arguments are logical. The political framework adds complications. China’s leadership doesn’t want to appear weak. They want some sort of agreement that they can claim will be great for them. Since any agreement will have to contain concessions relative to intellectual property rights and forced technology transfers, it will be skewed in our favor. Perhaps some good faith reduction (not elimination) in tariffs will be the compromise. Don’t expect any early solution, but don’t fear the lack of a treaty either. Time is against the Chinese and they know it. That is why they want to keep negotiations open.
Today, former Penn Charter grad and Atlanta Falcon quarterback, Matt Ryan is 34. Bob Saget turns 63.
James M. Meyer, CFA 610-260-2220