American’s enormous trade deficit – especially with China (a whopping shortfall of USD 375 billion alone in 2017) – is a thorn in his side. While the EU member states have now been (temporarily) exempted from any punitive tariffs, the focus is squarely on the Middle Kingdom where far-reaching trade sanctions have been imposed.
A look back in time
A very similar situation was to be seen earlier in the annals of US economic history: In the 1980s, Ronald Reagan set his sights on Japan. Over the previous decade, Japanese car manufacturers had managed to garner a relatively high market share in the USA within a short period of time. As a result, the major US car brands came under considerable pressure. Chrysler only narrowly escaped bankruptcy in 1979 thanks to an emergency government loan, and the mood at the time was just as heated as it is today. President Reagan responded by imposing punitive tariffs and pressured Japanese automakers to voluntarily restrict their exports. The conflict was finally set aside after Japan came to the conclusion that it would ultimately be the one to lose the most if the situation escalated even more.
A marriage of convenience
China owes its current economic standing primarily to the relatively free access it has to foreign markets. If this were to be made more difficult or even impossible, China would take a huge economic hit. But the US itself is also dependent on China, given the fact that China is America's largest foreign creditor (the Middle Kingdom holds over USD 12 trillion in US Treasuries). So at the end of the day, the two countries are stuck in an economic marriage of convenience. China has made itself vulnerable mainly through its past interventions in the foreign exchange market. The resulting currency weakness facilitated the export of ever-cheaper products. But the conditions for foreign direct investment are as well not in line with customary practice – one key example: foreign companies are only granted access to the country if the related technological know-how is disclosed. And in this regard, Donald Trump is not just sticking the knife in – he’s twisting it.
Will reason win out?
It is to be hoped that this situation will not become more aggravated. Donald Trump wants to use the aforementioned measures mainly as leverage towards initiating negotiations that lead to fairer trade conditions. The question is: Will China take the bait? Economic reason says “Yes”, but Beijing does not want to lose face. Moreover, China is currently seeking to gain its rightful political place amongst the established world powers. Its increasing arms expenditures are the best testimony to this. The Beijing administration is becoming more willing to take risks, as is anyway the case with Donald Trump. In Washington these days, hardly any conflict is side-stepped. Thus in a worst-case scenario, there is the very real possibility that a dangerous self-reinforcing momentum will develop. What is reassuring, though, is that China is reacting calmly (at least for now). Its announced countermeasures have been more symbolic than anything else: Beijing has slapped import duties of 25% on US pork and 15% on steel pipes, fruit and wine. In total, China has drawn up a list of 128 US products on which duties could be levied. The total value of the damage to the US economy is estimated at USD 3 billion. The Chinese side also stated that the conflict could not be resolved through more tariffs, but rather that the path of negotiation had to be sought. That sounds like a search for a solution, not for a gutter fight. In general, though, even if today’s acute trade spats are resolved, the topic of "unfair" conditions in the exchange of goods is likely to remain one of the top items on Donald Trump's agenda. This does not necessarily mean that a global "trade war" is in the process of being fanned. Rather, the customs debate could become an ongoing issue.
Stock markets remain volatile
The current uncertainty on the stock markets is driven by two important questions. How are capital costs developing and are protectionist measures hampering important investments? In their dimension, both questions cannot be answered at the moment, but both developments create corresponding headwinds for equities. We expect the cost of capital to rise gradually. This is done by rising interest rates, but also with increasing credit risks. While interest rates are currently rising significantly in the US, increased uncertainty in all regions influences volatility and thus credit risk. This development is not new and represents an important aspect of our equity strategy. With the advent of new trade disputes, higher production costs must be taken into account. The extent is not yet measurable, but represents a slowing factor concerning all future earnings expectations.
Correction in the uptrend
It is very important to keep in mind that both, long-term growth trends and long-term uptrends in almost all major stock markets remain unbroken. Currently, this difficult market phase can get classified as "correction in the upward trend". We do not see a break of the cyclical upturn currently but rather a slowdown. However, this means that leading sectors such as technology, industry or consumer discretion should continue to play a leading role over the coming months. Only an environment facing a significant increase in cost of debts and serious liquidity problems of highly indebted companies might trigger a cyclical downturn.
Two short-term alternatives but not (yet) a reliable solution
The markets "process" the current news more from an emotional perspective. This is because the effects cannot (yet) be grasped rationally. If the stock markets defend their February lows, the coming weeks will trigger a positive trading swing of 8 to 10%. However, if these supports fall, a further correction of up to 10% would be open. In both cases we expect a re-balancing afterwards. How does this view translate to the stock markets in Switzerland, USA and Germany?
In summary, we note that the stock markets during the current market environment «pricing-in» a new interest rate landscape but as well as increased difficulties in international trade affairs. However, growth is still intact. Thus, in this market weakness, we see a correction in the uptrend and going forward higher volatility. In all cases, however, investors should check their equity positions concerning their fundamental quality. Companies with too high operational leverage, unsustainable business models but also high entrepreneurial expectations (or speculations) will be heavily audited in the coming months and tend to be the losers.