After a 20% decline for the S&P 500 Stock Index from September 21st to December 24th, the US stock market completed a rapid round-trip recovery back to new highs. There were two primary catalysts for the big rebound in stocks: (1) the Federal Reserve announced that it was retreating from its previous monetary policy path of steadily raising short-term interest rates and planned to just keep them where they are for the foreseeable future; and (2) increased optimism that a trade deal between China and the US was imminent.
The trade deal recently ran into unexpected snags, and it isn’t entirely clear what happens next. President Trump believes that China backtracked on issues already mutually agreed to in hundreds of pages of details regarding a trade deal that was thought to be 95% complete. The President angrily responded by increasing pressure on China by announcing a step-up in tariff rates from 10% to 25% for a list of $200 billion in Chinese exports to the US. President Trump also said that he may escalate the trade war further by slapping 25% tariffs on an additional $300 billion worth of Chinese exports to the US, broadening the trade war to cover all Chinese exports to the US.
If the trade war expands further to cover the entire list of all goods traded between China and the US, economists estimate that might subtract about 1% per year off of the annual growth rate of Chinese GDP, and that it could reduce US GDP growth by about 0.5% a year. Given that both parties are hurt from an ongoing trade war, the hope is that calmer heads prevail, and that China and the US return to the bargaining table and compromise on a trade deal. China’s economy is more trade-dependent than the US and thus has more economic sensitivity, but President Trump can ill-afford a protracted trade war because a slowing economy and slumping stock market would hurt his 2020 re-election campaign.
In addition to the Chinese retaliating with tariffs on US exports to China, China might also take alternate means of retaliating against the US, such as liquidating China’s US Treasury bond holdings as well as boycotting future US Treasury bond auctions. The nation’s most prominent bond fund manager, Jeffrey Gundlach, is deeply concerned that the size of the US deficit and national debt are both “out of control.” Gundlach thinks that a $3 trillion budget deficit is possible when the next recession comes along. He gave a slide presentation in March, provocatively titled “Highway to Hell,” in which he argued that if our national debt continually grows faster than our nominal GDP, then there is trouble ahead. If China refuses to finance the US fiscal profligacy, that may be an additional concern.
President Trump and China’s Xi Jinping are already scheduled to be together in Osaka, Japan for a G20 Summit meeting on June 28-29th, and that would be the most convenient date for President Trump and Xi to sign a renegotiated deal if it comes together in the next few weeks. Goldman Sachs economist, Jan Hatzius, believes that the most likely outcome—about 70% odds—is that China and US will compromise in coming weeks and sign a trade deal at that June 29 meeting between Xi and President Trump. Hatzius sees a 30% chance, however, that the US and China will not be able to agree on a deal by the end of June, and that the trade war could then escalate further and impact all cross-border trade between China and the US.
The US economy has recently looked resilient, with steady growth, but the global economy, on the other hand, has been steadily slowing down and appears more vulnerable. While the most likely outcome is that China and the US will reach a compromise in the next 4-6 weeks, an escalating trade war would be a further problem for an already vulnerable global economy, and the concern is that weakness in overseas economies could potentially feed-back and help tip the US economy into recession as well. Given the uncertainties surrounding the impact of the trade war on earnings and the global economy, investors should be prepared for a little more stock market volatility in coming weeks as trade war tremors continue.