Fear the stimulus more than the trade wars

Thu 23 May 2019

It feels that Donald Trump’s “trade wars” with China have come to dominate financial headlines as they were considered the main culprit for last week’s stock market correction. However, a closer look indicates that the whole issue is, at this point, essentially noise, both in terms of market indices and the economy.

First of all, the stock market correction is relatively small, with the S&P 500 only 2.3% from its record high levels at the close on Thursday. The problem is not so much the one trade event, but rather an overall lack of catalysts to support fresh high levels. The profitability of US companies, although somewhat better than expected (analysts expected a 4% earnings drop, more than the actual 0.5% drop), is hardly something to celebrate. On top of that, we have entered May, traditionally a period of lower returns. Failure to reach a trade deal was just the final catalyst traders were looking for.

The economy

The global economy has slowed since last year. At the end of 2017 it was growing at 3.7%, while for 2019 the IMF estimates economic output growth of around 3.2%.  Very often, economic analysts note the similarities between the current US policy with the Smoot-Hawley tariffs of the 1930s, which led to the collapse of world trade. However, we are still far from this era, when all countries declared tariffs against the US at the same time and when the 1929 Crash was still a recent event. OECD studies show that global tariffs, even with Mr Trump’s moves, remain at relatively low levels.

Though many point the finger at Mr Trump’s trade policies, the real causes for this slowdown must be sought in other policies, and in particular in internal “pro-cyclical” policies to stimulate the economy at the peak of the economic cycle. As the IMF (1) and the OECD (2) have confirmed, Mr. Trump’s recent tax cuts have led to a significant repatriation of US dollars, hitting growth and Foreign Direct Investment worldwide. America, traditionally the world’s largest investor, shied away from that role for the first half of 2018, which led to an economic slowdown domino effect, particularly in Europe, as funds left Germany and Ireland.

Making America Great Again

Donald Trump remained loyal to his election slogan “America First”. After World War II, the largest economy in the world has often exchanged growth for influence. Now, as global growth has fallen sharply compared to historical averages, following the 2008 Global Financial Crisis, America has had less growth to share and, gradually, less appetite to share it. Especially since American politicians understood the implications of their big rival, China, becoming the largest economy in the world.

China

China is undergoing a period of significant economic transition, shifting the focus from the secondary economy (factories) to the tertiary (services), and from exports towards the domestic consumer. Normally, success for an economy of this size would take decades. This is especially true, as the transition is plagued with persistently high savings rates (the Chinese do not receive significant state pensions, so they save much and do not invest) and important demographic problems arising from the previous one-child policy. The Communist Party’s persistence to achieve the transition target in a very short space of time is in any case dangerous to the economy, as very important reforms are being promoted (such as reducing dependence on the “shadow economy”) in a very short window for the market to successfully absorb them.  The US President’s moves to stimulate his own economy at the expense of America’s trade partners risks further destabilization of the Chinese economy, which could have an impact on the entire global supply chain. It is simply impossible to believe that a further Chinese slowdown would leave the American economy unscathed.

What does this mean for investors?

From a stock market point of view, “trade wars” are at present only a catalyst for further high levels, the absence of which could lead to more “sideways trading”, rather than to a significant market fall, mostly thanks to central bank stimulatory policies. From an economic point of view, they are clearly less important than other policies in destabilising global trading patterns.  The end of the economic cycle is approaching after a decade of growth, as growth peaked at the end of 2017, according to the OECD. The question in the minds of investment funds is relatively simple: are loose monetary policies of central banks enough to stave off a 2008-like crisis, or are the risks out there more real than we currently think? We believe the answer is the former, and as long as focus is not on debt levels or inflation, stimulatory policies can be very successful in containing risks.

Notes: (1) IMF World Economic Outlook April 2019
             (2) OECD FDI In Figures: Global FDI drops 27% in 2018 following the US tax reform