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Trade War at the Crossroads

The corkscrew path of trade negotiations with China were dealt another twist in late November by the passage of the Hong Kong Human Rights and Democracy Act (HK Act) by the US Congress.  The HK Act requires the US government to impose sanctions against Chinese and Hong Kong officials responsible for human rights abuses in Hong Kong, and require agencies, including the Department of State, to conduct an annual review to determine whether changes in Hong Kong’s political status (its relationship with mainland China) justify changing the unique, favorable trade relations it enjoys with the US.  This favored status is based on a 1992 law under which the US treats Hong Kong as a separate jurisdiction from mainland China. It means, for example, that the holders of Hong Kong passports can travel more easily to the US than their mainland cousins. It also means trade between Hong Kong and the US is not subject to the tariffs imposed by Washington on trade between the US and mainland China.

China runs Hong Kong under a “one country, two systems” model whereby the territory enjoys freedoms not enjoyed in mainland China, like a free press, though many people in Hong Kong fear Beijing is eroding this. The government denies that.

The HK Act was passed unanimously by both houses of Congress, and after reconciliation of some differences, passed the final vote in the US House by 417-1.  It is rare to use the words “Congress” and “unanimous” in the same sentence these days, underscoring the unique moment this legislation represents. It is a clear challenge to the heavy-handed repression with which the mainland Chinese government is coping with the insurrection in Hong Kong.  China’s promise to maintain Hong Kong’s legislative and judicial freedoms, a legacy from 150 years as a British colony, have evaporated like a summer rain in the desert. Speaker Pelosi said after passage “The Congress is sending an unmistakable message to the world that the United States stands in solidarity with freedom-loving people of Hong Kong and that we fully support their fight for freedom.”

China doesn’t see it that way.  China’s array of official mouthpieces have already swung into a chorus of condemnation.  Fiery criticism from the National People’s Congress, the foreign ministry, and state media warned of unspecified countermeasures against interference in China’s affairs.  This has left no doubt that some sort of retaliation would follow passage of the HK Act. The Chinese government’s top diplomat delivered a stinging attack at the G20 meeting in Japan.  Not mincing words, he stated the United States has used its domestic law to “crudely interfere” in China’s internal affairs, trying to damage “one country, two systems” and Hong Kong’s stability and prosperity.

The HK Act has now landed on Donald Trump’s desk for signature, or veto.  He faces a choice with no palatable options, because regardless of what he does the Chinese will be incensed.  If he signs the bill, as reports indicate, he will be seen as directly challenging the Chinese political overlords, and alienating the very nation he is trying to woo to accede to our trade demands.  If he vetoes it, the bill goes back to Congress, where the unanimity of its initial passage virtually assures that the veto will be overridden. In either case the US will be throwing down the gauntlet to China in a direct challenge to its one country, two systems approach.  Trade relations are at a crossroads, as any progress is likely to be undone by China’s retaliation for the HK Act.

Stock markets have taken the HK Act and the ongoing protests in stride, and have recently traded up to new highs.  Markets have been held hostage to snippets of news reporting on the progress of the US-China trade talks, with hints of progress met with euphoric buying and signs of trade stalemate sending stocks lower.  “Fear of missing out” seems to be the overarching strategy for investors as stock markets seem oblivious to the broadening signs of global slowdown.

Wall Street’s new highs are occurring against a backdrop of economic reports that are softening.  The US is not in a recession yet, but data shows a consistent weakening in activity. The regional Fed indexes for Dallas, Chicago, and Kansas City all hover around zero, markedly lower from a year ago, but currently toeing the borderline that would indicate a broader slowdown.  

The Leading Economic Indicators have also backtracked, having fallen three months in a row.  In the six months ending October 2019, the LEI decreased 0.1%, a reversal from its growth of 0.4% over the previous six months.  And a corollary index, the Conference Board’s consumer confidence index, has now dropped four months in a row. This string of declines is the longest since March-June 2012 and shows cracks may be emerging in what’s been the economy’s mainstay-consumer spending.

The transportation industry is already in a recession.  The Cass Freight Index ( for October made grim reading, with the index falling another 5.9% year-over-year.  This marked the eleventh month in a row of negative freight volumes, with the index now erasing two years of growth.  This prompted the editors to flatly state that “we repeat our message from the previous five months: the shipments index has gone from ‘warning of a potential slowdown’ to ‘signaling an economic contraction.’”  The transport recession has finally hit home, as Cummins Engine, one of the world’s largest heavy engine makers, announced layoffs of 2,000 workers as “demand has deteriorated even faster than expected.”

Finally, world trade contracted sharply in September, dashing hopes that the global downturn that has been weighing on exporters has bottomed out.  The volume of global trade dropped 1.3% in September, according to CPB World Trade Monitor. Compared to the same month of 2018, global trade contracted 1.1%, marking the fourth consecutive year-on-year contraction, and the longest period of falling trade on this measure since 2009.

How can stocks be reaching new highs, while fundamental economic reports seem to be weakening and deteriorating?  The answer lies in the decision to restart “quantitative easing” (QE) by the Federal Reserve and the European Central Bank.  The ECB is trying to spur a continent seeming to teeter on recession, having been hit hard by the global trade slowdown. The Fed, in response to a September choke-up in the overnight money markets that briefly sent yields as high as 10%, is trying to keep order by buying billions of dollars (again) of short-term Treasury bills.  After months of shrinking its balance sheet, the Fed vowed to buy $60 billion worth of Treasury bills per month through the spring of 2020. As a result, the Fed’s balance sheet has swelled by $286 billion since early September, to $4.05 trillion.

The decision by the Fed to ramp up the size of its balance sheet was a tacit admission that the central bank erred by shrinking its balance sheet, and unintentionally drained too much cash from the financial system.  That left markets exposed to a liquidity crunch. Now, the Fed is fiddling with the dials, trying to determine precisely how much cash is needed to keep the system operating smoothly. The entire episode is a reminder of how, behind the scenes, modern central banking is very much an experiment. And experiments often bring about unintended side effects.

A look at the best-run pension system in the world provides a glimpse into one of the unintended effects of QE policies.  The Dutch pension system has been held up as a model of integrity due to its strict accounting and reliability, and was ranked first in investment adviser Mercer’s 2019 annual review of global pensions.  An extended period of record low, and even negative, interest rates has put huge pressure on these pension funds, forcing them to alert retirees that their incomes could be reduced. Years of QE have cut the income pensions can receive from their investments drastically, and now QE’s impact on pensions worldwide is being felt.  If the well-funded Dutch pension system is contemplating cuts, what will the harvest be for the many underfunded state and municipal plans in the US? A growing lack of trust in pension systems could have a broader economic impact if it causes consumers to rein in spending, thus creating the opposite effect of QE’s intended goals.

Investors today are faced with a profound question: Do fundamentals matter anymore?  Can the broadening signs of economic weakness be safely ignored, as long as central banks keep pumping liquidity into the financial system?  Can increasingly hostile relations with China be papered over with more cash? 

Our answer is that fundamentals do matter, ultimately.  QE policies have only been in place since the dark days of 2008, when there was plenty of spare industrial and labor capacity.  This helped create a virtuous cycle of growth as we recovered and rebuilt from the Great Recession. As global trade slows and company’s business prospects get dimmer, will they be quite so willing to add even more debt to their balance sheets?  Moreover, this is the point in the business cycle when the corporate weaklings will start to feel the pain from dwindling revenues and cash flow. If we see some notable bankruptcies in the coming months, we expect the willingness to lend to corporate America will diminish also, putting pressure on company earnings and dampening Wall Street’s hopes for a robust 2020.

Finally, if current softness feeds through to the labor market, then the remaining prop to US growth, the almighty consumer, may come under threat.  Employment is a lagging indicator, so it would be natural to see any negative news in this sector follow deterioration in broader economic indicators.

Investors are at a crossroads also.  Stock market valuations are approaching the extremes last seen in 1999-2000, pricing in a very rosy future, but leaving little room for error or disappointment.  Investor sentiment is again very bullish, a negative from a contrarian point of view. And finally, the fundamental effects of worsening trade activity are now starting to be felt all through the global manufacturing chain.  We would urge investors not to be fooled by the distorting effects of QE and keep an eye on economic fundamentals to reassure themselves they are consistent with the current bullish message of the markets.

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