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Economy - May 27, 2019

Trump, Jinping Play Poker

The US-China Trade War has been like a drawn out game of poker, with cards played and chips wagered. Questionable rhetoric from each player, exchanged between hands dealt, has only exacerbated the intensity of the situation.

For investors wondering how the Trade War will affect the US economy and stock market, several key questions come to mind:

How much can the trade balance really affect US economic growth? How much do fluctuations in the Yuan’s value against the US Dollar affect the situation? What is the impact on the US economy and the stock market? Should new developments be acted upon, or is the day-to-day rhetoric overemphasizing long term effects? And finally, what are the key levers to watch moving forward?

There is little doubt that when all the cards have been dealt, the world’s two largest economies will be markedly changed, though we may not have perfectly clear answers to the questions above.

Instead, the effects on the United States and China, their economies and their citizens, can only be evaluated in piecemeal — measuring the effects of each wager and counter.

Consumers will be affected

Because the first few rounds of tariffs were applied mostly to items that businesses purchase, rather than those on the average person’s shopping list, consumers initially didn’t feel impacted.

Additionally, since the effects of all tariffs, adopted and proposed, are yet to be fully realized, it’s hard to be sure of the ways, and the extent to which, consumers will be affected; however, some examples have already manifested.

Certain tariffs that were recently raised from 10% to 25%, and the latest $300 billion slate of goods, affect items such as frozen food, clothing, and electronics. As a result, US consumers are already feeling the impact in their regular spending habits; that impact will be even greater if the newly proposed tariffs go into effect.

According to the Peterson Institute for International Economics, the effect of recently proposed tariffs would be similar to a $2,200 tax hike for the average American family and effectively wipe out the $800 in average savings that last year’s federal tax cuts delivered.

In China, the effects of the Trade War can be added to a growing list of domestic concerns:

The Chinese economy’s recently dampened growth has led Premier Xi Jinping to call on citizens to prepare for a “new Long March”, a period of struggle similar to that during China’s civil war in the 1930’s. Additionally, external factors have caused prices for staples like pork and fruit to skyrocket. Chinese citizens have grown frustrated and #FruitFreedom is trending on Chinese social media as a result of consumers’ frustration.

Imports & Exports

What prompted Trump to bet big on tariffs in the first place? The US-China trade balance — or lack thereof.

The United States’ GDP, a vital indicator of the economy’s health, is directly affected by the trade balance in the form of Net Exports. Thus, a beneficial trade balance directly contributes to the US economy’s performance.

Speaking in absolute terms, the United States imported just over $540 billion worth of goods from China in 2018; in the same year, the United States exported just $121 billion of goods to China, meaning the US imports from China about 4.5-times as much as it exports to China.

On a relative basis, the chart below shows the percent changes in exports to, and imports from, China on a quarterly basis since Q2 of 2016. While the two figures were trending in tandem for some time, US Exports to China fell sharply to $22.6 billion in Q4 of 2018, down from $30.7 billion in the previous quarter. That’s the opposite of the tariffs’ desired effect.

The fact of the matter is that so far, efforts by the United States Trade Representative and the executive branch have been a mixed bag — winning some hands and losing others. While US Exports to China fell sharply at the end of 2018, they rebounded in Q1 2019. Over the same two quarters, US Imports from China fell $16.3 billion, from $135.1 billion to $118.8 billion, the largest single quarter drop on record.

Answering the earlier proposed question — How much can the trade balance really affect US economic growth? — we saw a record drop in imports from China to start 2019, and in the same quarter, US GDP Growth topped estimates at a surprising 3.2%.

However, the effects of tariffs and trade balances are tricky. If the US government pushes too hard on tariffs, it may succeed in improving the trade balance (as it did in Q1 2019) while adversely affecting other GDP inputs such as consumption and investment.

As more and more tariffs are announced, the pot in the center of the table grows.

Currency Swings

When the Trade War rhetoric started, the never-ending poker game began, and FX volatility came with it.

The chart below shows the US Dollar to Chinese Yuan exchange rate over a three year period, including the entirety of President Trump’s administration. Several jarring movements stand out.

In April 2017, President Trump and Premier Jinping agreed to engage in 100 days of trade talks with the intention of addressing the US trade deficit. Though no agreement was reached, the US Dollar gradually became less valuable and moved from about ¥6.88 to ¥6.55 per $1.00 — a good thing for improving the trade balance.

By January 2018, when 25% and 10% tariffs on steel and aluminum, respectively, were announced, the exchange rate plummeted to a 3-year low of $6.275/¥1.00.

At this point, in April 2018, Beijing check-raised with their own 25% tariffs on a lot of 128 US goods, and the two governments traded big bets — more tariffs on more goods.

The swift depreciation of the US Dollar in the second half of 2017 was the original intention of President Trump — a lower valuation of your currency should stimulate exports — however, the Dollar-to-Yuan exchange rate ended 2018 at nearly the same level that it was when Trump proposed the first of the trade tariffs in early 2017.

Trump grew his stack of chips considerably, then played into a cooling deck and lost all he had gained. Volatility has persisted in 2019 as the Dollar devalued against the Yuan but is currently trending toward its 3-year high.

Our question was: How much do fluctuations in the Yuan’s value impact or offset the effects that tariffs have on the US-China trade balance?

With announced tariffs in the 10–25% range, a 10% decline in the Yuan compared to the Dollar would offset the tariffs’ effects, assuming prices remain constant. That said, if the Yuan were to move beyond its historical $6.25–7.00 range, the world economy would be affected beyond tariffs’ impact.

Looking Ahead

Both the United States and China have been beefing up their nationalistic rhetoric with the assumed objectives of quelling domestic concerns and agitating each other’s governments.

Premier Jinping has sent symbolic messages to the United States by way of public appearances and speeches. Inciting the “new Long March” at a dedication ceremony was directed at Chinese citizens but also sent a message to the United States government: “we have enough chips to wait this out.”

What is the Trade War’s impact on the US economy and the stock market? And should investors react to news as it’s announced?

Thus far, the market has exhibited some knee-jerk reactions to major headlines like new tariff announcements or canceled discussions; however, more tangible market influencers such as growing corporate profits, falling unemployment, and interest rates have had broader positive influence on the stock market. Investors, especially those with long-term horizons, should respond to Trade War news only to the extent that the factors mentioned above are impacted.

The chart below shows the S&P 500 and MSCI China TR Index percent change over the last year. The slowing of the Chinese economy is evident, as is the volatility that trade war concerns have had on the US markets.

Meanwhile in the US, Trump’s latest tariff proposals have caused spectators of the poker game to jeer as cards are turned over.

Footwear and apparel companies like Nike (NKE), Under Armour (UA), and Adidas, plus 170 other retailers have organized their discontent with the Trump administration’s latest tariffs. The tariffs include footwear, and the Footwear Distributors and Retailers of America estimates that increased prices will cost US consumers over $7 billion each year.

What are the key levers to watch moving forward?

First and foremost, the trade balance and whether its narrowing trend continues or widens back to average levels. Corporate profits are also key when evaluating the health of the market; investors should focus on earnings releases and both top and bottom line growth.

Finally, the relationship between interest rates and the strength of the Dollar. With low rates and a strong Dollar, purchasing power will remain. If interest rates are raised and the dollar weakens, consumer spending may be negatively affected.

There’s a lot of cards left in the deck, and the players are growing weary. As the game goes longer, and the discussions drag on, one or both parties might be more inclined to make a final, all-in bet, and could ultimately pay for it. Governments and investors should both recognize that sound decision-making becomes only more important as more cards are played and more chips are earned.

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