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By Nathan Chaudoin & Joyce Huang, CFA - May 13, 2019
Last week’s escalation in U.S.-China trade tensions has sent stocks plunging. In the ensuing sell-off, investors fled to the perceived safety of the U.S. Treasury market, driving yields lower.
Although this latest round in the trade conflict has led to heightened global market volatility and uncertainty, we still believe a compromise remains the likeliest outcome. However, negotiations remain fluid, and it’s challenging to predict when the compromise will emerge.
Given the U.S. move to increase tariff rates from 10% to 25% on $200 billion worth of goods and threaten 25% tariffs on another $300 billion, it’s difficult to still consider this a negotiating tactic. The same can be said for China’s retaliatory tariffs on $60 billion worth of U.S. goods. These tit-for-tat moves seem designed to save face as both sides appear to position themselves as unwilling to blink first.
Nevertheless, it’s in both countries’ best interests to forge an agreement sooner rather than later. For the U.S., the incentive is largely political. Any “win” on the trade front would give President Trump an important victory heading into presidential campaign season. He also can argue that higher tariffs on goods from China help protect American manufacturing from cheaper Chinese imports. From an economic perspective, it appears the U.S. may have taken this year’s U.S. stock market rebound as a sign that the already-imposed tariffs on China are not having a negative impact on the U.S. consumer and economy.
For China, the incentive to strike a deal is largely economic. China exports significantly more goods to the U.S. ($558 billion in 2018) than the U.S. exports to China ($179 billion in 2018), and China’s economy remains much more vulnerable to higher tariffs. We expect China to use all the tools at its disposal to support its economy and help offset the impact of new tariffs, including quantitative easing, tax reductions and infrastructure spending. We will also watch to see if China allows its currency to weaken as another way to counter the tariffs’ impacts.
Escalating trade tensions likely will have near-term negative effects on market direction and global trade. However, it’s important to recognize that global monetary policy dials—including the U.S. Federal Reserve—have already turned toward supporting global economies and markets. Furthermore, China’s economy is in a much better place today than when the trade conflicts began. Policymakers have employed significant stimulus in that time, and they have ample options for additional action.
We expect the equity markets to favor companies that can deliver growth and are exposed to China’s fiscal spending. China’s domestically focused companies should outperform, supported by the government’s stimulus.
Despite these reasons for optimism, further escalation of the U.S.-China trade tensions looms as a threat to global growth. We are reluctant to speculate on the next moves in the chess game by either player. In the meantime, we continue to carefully monitor the situation and its effects on global equity markets.
From a fixed-income perspective, we view the escalation in the U.S.-China trade dispute as “noise.” But that noise likely will cause some short-term volatility throughout global bond markets until the U.S. and China strike a deal. Accordingly, we’ve added some hedges to our corporate bond positions to help mitigate the impact of spread widening. Most of the credit exposure in our U.S. and global fixed-income portfolios remains in the U.S. and Europe. In our emerging markets portfolios, we have minimal exposure to China.
Of course, securing a U.S.-China trade agreement would be a positive factor overall. A trade deal likely would jolt the global economic outlook, ultimately pushing yields in developed markets higher. An agreement would also benefit the bond markets in emerging markets countries engaged in global trade. Furthermore, we would expect U.S. and global credit spreads to tighten on the news. Absent an agreement, the opposite would be true.
However, we don’t believe ongoing trade tensions and higher tariffs will have a significant effect on the corporate bond market. We would expect some challenges within specific industries, such as automotive, information technology and agriculture. But we don’t believe the impact will be material enough to have a major impact on company credit profiles. In general, large investment-grade corporations don’t have concentrated exposure to China’s market. Furthermore, companies can take mitigating measures to lessen the impact of tariffs. For example, companies may raise prices, renegotiate supplier contracts or relocate final production steps.
It’s important to note that the latest round of U.S. duties won’t affect any goods that have already left China’s shores for the U.S. Likewise, China’s recent round of tariffs isn’t scheduled to take effect until June 1. It takes approximately two to three weeks for ships to travel from China to the U.S. And in that time, both sides can continue negotiating. Indeed, high-level talks continued even after both sides announced new rounds of tariffs. We believe this latest escalation may not be that damaging if talks remain ongoing.
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