Trade and Equity Market Dynamics Dominate

The increase in equity market volatility preceded the escalation of trade tensions, but now the latter appears to be stymying attempts to stabilize the former.   The equity market was its own dynamics, and last year's low volatility was an anomaly and payback, as in reversion to mean, is painful.  

Following the list of the specific Chinese goods that would hit with US tariffs for the intellectual property rights violation claims and the list of US goods, China would target, the S&P 500 posted a reversal pattern in the middle of the week.  It traded on both sides of the previous day's range and then closed above the previous day's high.  There was follow-through buying on Thursday, but Trump threat to double down by instructing the US Trade Representative to identify an additional $100 bln of Chinese goods to slap an additional levy threatened fresh escalation and saw stocks unwind their gains.  

Some observers are keen to point out that there are not another $100 bln of US goods imports that China can put a tariff on to match the escalation.  But they do not seem to know what to do with that observation.  Surely it does not mean game over.  They seem confused. Do they hold Chinese officials in such low regard as to assume they can only see the next step?  Isn't it the US that is accused of short-termism compared to China's long-game?  

There are many other areas that China can demonstrate its displeasure.  Many observers jump to the selling US Treasuries or to depreciate the yuan.  However, for numerous reasons these are non-starters, and we encourage investors and policymakers not to be content with such answers, and we prepared for other responses.    

A decline in China's Treasury holdings may not send a clear signal as it takes a while to detect, may not have much impact, and could distract from China's own reserve and currency strategy.   When China's  Treasury holding fell by $200 bln over a six-month period in 2016,  the impact on US yields was not perceptible.   China's actions could simply be lost in the deepest and most liquid market in the world.  

Nothing fails like success.  If China broadcast its intentions to sell US Treasuries, it would undermine the value of its substantial portfolio, if it were successful.  Also if it were successful in driving up US interest rates, and weakening the US economy, it would be cutting its nose to spite its face as it would undermine its single largest customer.   China would also have to redeploy the capital it takes out of the US Treasury market.  It would give up significant yield and liquidity to go into German, French, and Japanese bonds.  Many talk about a shortage of German paper given the private sector and ECB demand. 

Similarly, many pundits emphasize the risk that China could devalue its currency to offset in whole or in part the effect of US tariff.  It is cited as a threat.  This too would seem to require a change in China's strategic decisions about the yuan and macroeconomy.  Moreover, in recent months, the only major country to appear to talk down its currency is the United States.  It was sufficiently salient that it was also discussed at length at the ECB meeting in February.  To be sure, the US quickly walked back like a child who trespassed might.  

MAD, as in Mutual Assured Destruction, was the logic of the Cold War.  It required establishing superiority at every rung in the escalation ladder.  China's endowments lend itself to a different game.  It may be more inclined to asymmetrical responses--jumping to different ladders, as it were,  It is not like China plays chess while the US plays checkers.  Try Go.  

The idiosyncratic nature of the Trump Administration ought not to blind investors to the fact that the trade antagonism with China is widespread.  The chief disagreement on the issue is over tactics of the Trump Administration and its unilateral approach.  There is a general frustration with the gap between China's declaratory policy (what it says it will do) and its operational policy (what it does). 

There is a great deal of posturing and signaling.  This is still in the realm of negotiations, which is why many of the war calls are premature.  They are troublesome because they help foster the kind of mindset that is self-fulfilling.  Remember the old Cold War maps in the US that showed Russia to the east and west and north of the United States, making it look like it was surrounded.  That kind of mentality is subtle and growing and directed at China, as the Wall Street Journal's chart of China's trade surplus with the US beginning with the Tiananmen Square massacre.  It is not that the massacre is important, but its inclusion on a chart on trade imbalances is a gratuitous attempt to stir animosity.   

Like American officials in the 1960s willing to burn a village to save it, the Trump Administration is willing to put the entire trading system at risk to enforce its interpretation of the rule of law.  This willingness will likely generate some concessions from economic rivals, including China.    Whether this constitutes success or not is a different story.  The forces that drive the broad trade balance are many and varied, and the additional fiscal spending when the US economy is growing above trend will likely be translated into a larger rather than smaller current account deficit.  

One consequence of escalating trade tensions with China is that it may make the Trump Administration more willing to compromise on NAFTA.  After again threatening to withdraw from NAFTA, the Trump Administration let in be known that it was willing to compromise on domestic content rules to facilitate an agreement (in principle) at the Summit for the Americas  (April 13-14). 

An agreement would be a big win for Trump and would strengthen his hand against domestic rivals and in negotiations with China.  Many heralded the deal with South Korea as an important victory, but it was a one-off, in the sense that the leverage was unique.  A NAFTA agreement would demonstrate that Trump can secure more gains that have been generated by trade for the US.  It would allow the concentration of US efforts for the bigger confrontation with China.  Canada and Mexico also have vested interest in securing an agreement, lifting the uncertainty, which the Bank of Canada has cited as a policy consideration.  

Our last point about trade is that the flexibility of it should not be underestimated.  And therein may lie investment opportunities.  For example, if China implements a 25% tariff on soybean imports from the US, doesn't that pose an opportunity for the mills to sell soybean meal and charge a premium for their services?  

It is still the early days, but the impact from the US tax cuts remains elusive.  Consumption looks to have slowed in Q1 from Q4.  Consumption has slowed, and before the weekend, the US reported the consumer credit growth in February slowed to $10.6 bln,  the least since last September ($8.6 bln), was the weakest growth in five years.   Nor have factory goods orders or durable goods orders increased to reflect a pick-up in investment in plant and equipment.  In the first two months of the year, factory goods orders and durable goods orders excluding the military and airplanes have in fact slipped slightly.  

The S&P 500 managed to finish last week above its 200-day moving average, but it was still around a percentage point lower than when European markets closed.  The cuts in the corporate tax schedule are expected to generally lower the effective tax rate as well.  Exemptions (popularly know as loopholes) were mostly untouched.  Some multinationals, including apparently some financial institutions, will have a tax obligation for retained earnings overseas, whether or not they repatriate it.  Earnings expectations may be preventing or deterring a capitulation in the equity market.  

The high-frequency economic data schedule is light and reminds one of the Woody Allen character that complains about a restaurant saying that the food wasn't good and the portions were small.  What data is coming out, it not so important for the policy outlook and will be overshadowed by the equity market performance and the evolution of the trade issue.  

The eurozone reports February industrial production figures, and after Germany's downside surprise before the weekend, a weaker report than the median forecast in the Bloomberg survey (of 0.1%) would not surprise.  Following the 1.0% decline in January, it shows that the weakness of the survey data (PMI, ZEW, IFO) has indeed been a fair lead indicator and not simply a technical adjustment.  That said weather appears to have exaggerated the economic pullback.  

The eurozone trade surplus is expected to have grown in February, and its announcement will not help ease US-European trade tensions.  The exemption from the steel and aluminum tariffs expires at the end of the month.   

The UK reports industrial output and trade as well.  Sequentially, the UK is expected to report favorable economic news. This will serve to underpin expectations that the Bank of England hikes rates next month. 

Japan reports its current account figures for February.  The problem from deducing unfair trade practices from its current account surplus as some wish to do is that it is not driven by trade.  The unadjusted current account surplus is expected to be around JPY2.2 trillion in February.  Of this surplus, only JPY250 bln (~20%) is from the trade balance.  The lion's share of the rest is from income generated by direct and portfolio investment abroad.  This includes royalties, dividends, licensing fees, profits, and interest.

The most important US economic report will be the March Consumer Price Index.  Even if the headline is flat, as the median forecast in the Bloomberg survey suggests, the base effect means that the year-over-year rate will rise to 2.4% from 2.2%. It would be the highest since March 2017.  More importantly, the core rate may be firmer (0.2% on the month), with the year-over-year rate moving back above 2.0% for the first time since last May. 

There is room for the market to become more confident of a Fed rate hike.  Bloomberg and CME calculations of the probability of a hike by June is nearly identical at ~78% and 80% respectively.  However, where there is a significant difference is in the May calculation.  Bloomberg's model suggests there is nearly a 26% chance of a hike at the May meeting, the CME model has it at 1.6%.  The effective Fed funds rate, which the contract settles at, has been steady at 1.69% this month but was 1.68% after the hike until quarter- and month-end. 

In any event, the implied yield of the May contract at the end of last week was 1.685%, which is where one would expect it on no change in policy.  There was no signal from Powell that there was a greater sense of urgency as rates hikes at back-to-back meetings would imply.  Neither the volatility in equities, the high-frequency data, nor the impact of the continued rise in LIBOR looks set to derail the Fed's course, for which recent doves like Brainard and Evans appear to have been won over.  

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