Published on May 13, 2019
After enjoying the stock market’s advance in each consecutive month so far in 2019, over the past week investors hit a speed bump, as U.S.-China trade issues have returned to weigh on sentiment. Headlines and signals emanating from both sides in recent weeks suggested an agreement was near. But according to Reuters, as discussions reached the final stages, the Chinese side stripped out legal language it had previously committed to throughout the draft document.
It appears that these commitments were in areas deemed critical by the U.S., including intellectual property protection, forced technology transfer, and verification of compliance. In response, on Friday the U.S. imposed additional tariffs on Chinese imports to begin at roughly month end, leaving a modest hope that in the coming weeks the two sides might reach an agreement that would avert them. The Chinese retaliated with incremental tariffs on U.S. imports, but their ability to respond in this fashion is somewhat limited, since they do not import as much from the U.S. as we import from China.
We believe it is likely that China has more to lose in this battle. The Chinese economy, while growing at about 6%, has been slowing for many years, and Beijing has engaged in a variety of measures to prop up growth, including lowering interest rates and setting ambitious targets for bank lending. The Chinese banking system appears to be highly leveraged, and may be susceptible to a slowdown in growth. Moreover, the Chinese economy is dependent on exports for a majority of its growth. In our opinion the U.S. economy grew strongly in the first quarter despite a government shutdown and severe weather that may have negatively impacted economic activity, and in general is not export-dependent for growth. The U.S. is not immune to higher tariffs imposed in this trade war with China, as many of the tariffs will be borne by consumers and/or companies. But tariffs are not likely to put a big dent in the economy’s overall growth, though some companies may be negatively impacted more than others.
Many companies that sell goods in the U.S. are re-working their supply chains so that they are not dependent upon China. Once such changes have been made, perhaps by shifting production to Southeast Asia or Mexico, they are unlikely to be reversed. In this regard, the longer the U.S.-China trade dispute persists, the more permanent the rerouting of supply chains will be, which has negative implications for China.
The U.S.-China trade dispute began over a year ago with targeted U.S. actions in sectors including solar panels, steel and aluminum, followed by broader tariffs. Against this backdrop, we have over the past year endeavored to bolster the resilience of our equity portfolios against the risk of escalation. In general we reduced our exposure to companies that we believe are vulnerable, while adding investments in areas that we thought would outperform a market pullback sparked by the trade dispute.
Nevertheless, we have retained some holdings which experience elevated volatility when trade-related issues hit the market. In general these are well-managed quality companies that we believe have a bright future. We expect they will provide attractive returns in the long run. In most cases, when the market is trending higher, as it has so far this year, these stocks benefit from an additional tailwind because of their exposure to cyclical economic growth. And should the U.S. and China again move closer to a trade agreement, these companies would likely return to market leadership. Our clients should know that we have taken limited action in response to the headlines of the last week, largely because we have factored the risk of trade escalation into our thinking over the preceding twelve months.