Last Updated: August 19, 2019
The U.S./China trade war will continue to generate lots of headlines, but I think the Chinese have lost. I am not sure if they realize this yet, but it makes no difference. That’s because U.S. companies with manufacturing facilities in China are now in full-out planning and execution mode to activate alternative facilities outside China. The cost advantages in labor rates are gone, and companies have decided that all the aggravations they have had to put up with (e.g., theft of intellectual property (IP), excessive rules and regulations) are not worth it. U.S. companies can find alternative sources of supply while China can’t find a replacement for the demand we generate for its goods and services.
Some worry that China will retaliate by selling their holdings of our Treasury bonds. I don’t believe they will do that. They need our bonds more than we need them as buyers. Why? China’s equivalent of social security is more seriously underfunded than ours and there is no market in the world deep enough with high quality, long dated bonds as ours. Worse for them, if they sold our bonds, what would they buy instead? At present, $15 trillion of sovereign debt, all from the developed countries, sells at negative yields. With our Treasury bonds, they get call protected, high quality bonds—with a positive yield, no less!
The weakness in the yuan is telling as a symptom and it will likely make China’s problem worse. Inflation there would worsen if the currency weakens as the economy is slowing. The Chinese could be ready to learn what the term "stagflation" means. In the 70s, we in the U.S. learned it meant "stagnation" and "inflation." Couple this with what the recent protests in Hong Kong imply and one can conclude China does not have a great hand to play at the moment.
We believe the big problem for the markets right now is not that we will see a recession but that we will see a serious slowdown in profits. If there is a risk in the trade war, it is in the fact that it will simply make international trade more costly to conduct. It will, by itself, not be the cause of a recession but it could be a driver of slower growth. A growth slowdown could put profit margins under pressure, and the combination of slower revenue gains and smaller margins could lead to disappointment over earnings that don't match up to expectations.
Of course, we at SBH maintain a long-term viewpoint in our analytical work and remain focused on bottom-up fundamentals. If the global trade war does in fact result in near term earnings disappointments relative to consensus expectations, equity markets could indeed stay volatile and see further downside. As we’ve always counseled, investors should avoid the urge to make drastic short-term course corrections based on current headlines. For our clients, their portfolio manager remains the best resource to make sure their agreed upon long term asset allocation strategy is right for them.
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