Global markets are being held in the thrall of the expanding trade war. We are witnessing a degree of protectionism that hasn’t been seen since the 1930s. The chief combatants in this war are, of course, China and the U.S. Over the past two years, investors have keenly tracked trade negotiations, veering between panic and nonchalance. Reports of progress between the two superpowers have caused hopeful rallies in stocks, while setbacks have led to despairing plunges. Trade talks are partially being conducted on social media, where unexpected tweets have kept Wall Street off balance. Investors are trying to boil trade down to dollars gained or lost, the impact on earnings, and the effect on GDP. But we are witnessing more than a desire to set international trade on a more equitable financial footing. The face-off between the U.S. and China is nothing less than a titanic culture clash.
The trade war with China transcends economics. It is a battle of cultural wills. The American idea of liberal economics, based on private ownership, the rule of property rights, and the potential for prosperity or bankruptcy, has ruled western economies since WW II. Western Europe and Japan had the American model thrust upon them as they rose from the ashes of war, and met with extraordinary success. Russia (formerly U.S.S.R.) turned inward and spent decades futilely and often brutally trying to force reality to fit the theoretical ideals of communism. Finally, it collapsed in 1989 and broke up into various independent states. China followed the same path up to the early 1980s, but shifted to a more market-based, but still centrally controlled, economic model that has brought unprecedented prosperity to the country.
Many pundits felt China would follow the U.S.S.R. to stagnation and breakup. But the reforms of 40 years ago turned China instead into the world’s workshop. They welcomed all comers to tap into their massive fledgling industrial and consumer markets. But the price of admission was high. They often required the transfer and control of the technology of western firms, and then copied it for themselves. Know-how they couldn’t get voluntarily they “appropriated,” making intellectual property theft a key issue in today’s trade talks.
China’s ambitions are lofty. Their “Made in China 2025” effort, for instance, is a strategic plan that aims to move the country away from cheap, low quality goods to producing higher value products and services. It focuses on high-tech fields such as pharmaceuticals, autos, aerospace, semiconductors and robotics. It is also an attempt to move China’s manufacturing up the value-added chain, and become a major producer of high-tech goods in direct competition with America.
We believe Trump wants to do to China what Reagan is credited with doing to Russia, That is, use economic and military might to push the country back to some sort of second-tier, less threatening status.
But China is a country with thousands of years of history, deep cultural pride, and now a modern industrial base. Unlike Russia, which made nothing the west wanted to buy, China is manufacturer to the world. How likely is China to meekly acquiesce to U.S. demands? Not very likely, in our opinion.
The Chinese have two things going for them. First, they have a long-term vision of their preeminent role as a global superpower. This vision, of course, is mapped out by central planners, but nevertheless provides a long-term goal to strive for. They are not going to let their vision of global dominance be derailed by trade tariffs. Second, in 2018 president Xi Jinping pushed through a reform effort eliminating China’s two-term limit, effectively making Xi president for life. Thus, he can afford to play the long game politically, a necessary facet to seeing their long-term plans to fruition.
But China is not without its challenges also. Trump’s complaints on trade are understandable, as trade imbalances have reached unsustainable extremes in recent years. Another Chinese goal is to have consumers drive more growth. The shift from being highly export-oriented to consumer-oriented will cause some dislocations among Chinese businesses. Whether the government will allow exporters to go bankrupt in the wake of such shifts is an unanswered question, but should it happen, is likely to cause widespread social unrest.
A second potential weakness is China’s debt level. China’s central bank, like banks globally, have discovered the Pandora’s box of loose monetary policy. While it is hard to tell truth from fiction in Chinese economic statistics, it is widely agreed that stimulative monetary policy has left China sitting on a mountain of debt. Non-financial corporate debt has surged globally, and China is no exception. In the U.S., non-financial corporate debt has risen by 40% since the recession lows of 2008, and this represents debt equal to 74% of U.S. GDP. But this is dwarfed by China, where corporate-debt-to-GDP is a stunning 153% of GDP. China’s growth since the 2008 recession has been built on a house of debt, and deleveraging their economy while at the same time transitioning to a consumer economy, all while trying to avoid recession, will be a challenge for even the most zealous central planner.
No one should be under any illusions about the U.S.-China relationship, even if a trade deal is soon achieved. The deep differences in our respective economic structures mean trade relationships will be unstable for years to come. It is unlikely that a signed agreement will do much to shift China away from state-run capitalism. Vast subsidies for protected industries will continue, and the government will allocate capital through a centrally controlled banking system. U.S. attempts to compel China to enact market-friendly practices are unlikely to work as long as the Communist Party is above the law.
The fundamental clash of economic systems is not about tariffs, but global economic domination. Trade relations between countries require them to have much in common, including a shared sense of how commerce should work and a commitment to enforcing the rules. The world now features two superpowers with opposing economic visions, growing geopolitical rivalry and deep mutual suspicion. Regardless of how today’s trade war is resolved, that is not about to change.
Renewed trade tensions and faltering economic reports are prompting stock market bulls to rein in their optimism. Numerous companies, which had up until now predicted a second-half rebound, have thrown in the towel on their recovery hopes. Companies ranging from Deere to Intel have warned that the escalation of the trade war in recent weeks is almost surely going to impact their businesses for the remainder of 2019. This is already reflected in the downbeat reports for durable goods, capital spending, and manufacturing activity, all of which saw unmistakable declines in recent months. Freight and shipping activity has also shown obvious softness, as the process of transporting goods to market is reflecting the slowdown in activity.
Stock investors have, until recently, ignored the dark clouds on the horizon, believing that a resolution to the trade conflict with China was just around the corner. But reality has started to sink in, and investor optimism has started to sink as well. Stocks had rallied smartly to begin the year, as investors believed the late 2018 swoon was enough to create a bear market bottom and that company fortunes would recover in 2019. So far, this has not materialized.
Investors were encouraged by the ability of the S&P 500 and NASDAQ 100 indexes to get to new all-time highs in April. But they were the only two indexes to do so. The NYSE, Dow Industrials, and small-cap and mid-cap measures all trade below their 2018 highs. This is now becoming the longest stretch since 2013 that markets have not been able to achieve new highs, and many stocks are tracing out classic bearish patterns of lower highs and lower lows. This has resulted in a dog-pile into the stocks that have held up best this year, such as semiconductors and cloud-computing shares, but they, too, are now starting to falter. In contrast, utilities, real estate investment trusts, and steady dividend-payers have become the belles of the Wall Street ball as investors seek safety and income in the face of rising uncertainties.
Another beneficiary of the trade war stalemate has been government bonds. Previously shunned due to Wall Street’s almost universal prediction of higher inflation, and therefore higher interest rates, bonds have benefitted from the doubts about the economic outlook. Coupled with the Federal Reserve’s rate hikes over the past year, short-term bond yields are now above long-term yields, a phenomenon known as a yield inversion. Analysts get heart palpitations when yield inversions occur, because many inversions have preceded recessions. There is no guarantee that an inversion will cause a recession, but it has led more analysts to utter the “R-word” than any time since 2008. Clearly, a recession will occur if the nascent slowdown in business activity spreads to more sectors both here and abroad.
The stock and bond markets have been sending different messages so far in 2019, with stocks pointing to growth, and bonds forecasting a slowdown. Investors should pay close attention to their portfolios right now, as we may be at a tipping point of the economic upswing that has been in place since 2009. The markets are already being held hostage to the uncertainties of trade talks, and should China and the U.S. fail to find common ground, a more substantial decline in stock markets may make summer more hot and uncomfortable than ever.