Stock market sell-off underscores trade war dangers

As I write
this, there is a significant market sell-off underway, as fears about
escalating trade tensions have caused investors to panic. This sell-off should
not come as a surprise to those who recognized that stocks were vulnerable
because the market wasn’t fully pricing in trade tensions. I view this as a
healthy re-pricing of stocks to more fully factor in the potential that the
trade war is likely to drag on.

Last week,
all eyes were on the Federal Reserve’s (Fed’s) monetary policy committee
meeting. The decision was expected — a rate cut of 25 basis points — but there were
a few surprises. The first surprise was that the Fed also hastened the timeline
for ending balance sheet normalization. The other surprise was that many Fed
watchers walked away from the press conference with some confusion about how
dovish the Fed really is, and about the Fed’s rationale for the rate cut.

Fed Chair Jay
Powell had a very difficult task in trying to articulate the rationale for the
rate cut given a still-strong US economy — while also not wanting to cause
alarm. The Fed pointed to several different reasons for the cut. But I focused
in on one of them: The Fed cited
“uncertainties” in the global economy as one of the reasons, which is clearly a
reference to the trade situation.

The trade war has elevated economic

My takeaway
from the press conference is that the ongoing deterioration in trade relations is
a grave concern for the Fed; I believe the rate cut was an “insurance policy”
against the negative impact of trade wars. However, at this juncture, it is
difficult to quantify how damaging it may be, given that it is like a slow-motion
accident unfolding before our eyes. (I must note that this situation can still
be halted before maximum damage is inflicted.)

I call this a
“slow-motion accident” because, as I’ve said before, the primary cause of the negative
impact isn’t actually the tariffs themselves. It’s the economic policy
uncertainty they create, which undermines business confidence and tamps down
business investment — something Powell has pointed to in the past. (For
example, second-quarter US gross domestic product indicates
that the trade war has been impacting business confidence and investment, as
business investment fell 0.6% in the second quarter — the worst quarter for
investment in more than three years.1) Powell made it clear that trade policy uncertainty is
more elevated than the Fed had expected, but also suggested the Fed did not
need to act more boldly because the trade situation had stabilized: What he
described as having previously been “boiling” was now just “simmering.”

Trump announces
new tariffs on China

But that was a few days ago. Since then, the “simmering”
trade problems are back to a “boil.” One
day after Powell’s press conference, US President Donald Trump
suddenly announced he would impose new tariffs on $300 billion worth of imports
from China.2 This round of tariffs would impact a broad spectrum of
consumer goods — if they go into effect, it will mean that the US is now effectively
taxing every product that it purchases from China.

China’s reaction was unsurprising. Chinese
Foreign Ministry spokeswoman Hua Chunying stated
last week: “China won’t accept any maximum pressure, threat, or
blackmailing, and won’t compromise at all on major principle matters.”3
And today, Aug. 5, the renminbi
has fallen through the critical exchange rate level of seven renminbi to one US
dollar.4 While this has unnerved markets, I believe it is likely to
be a positive development for China. In my view, it should enable China to
better weather the new tariffs announced by the Trump administration, and it
suggests that China will not be forced into a trade deal with the US with terms
that are unsatisfactory to China.

This is
putting significant pressure on US equities — which were already spooked by the
deteriorating trade situation and eager to see a deal in the near term — and I
believe that is likely to continue. In my view, this underscores the reality
that China is in a far better negotiating position than the US; it has far more
tools it can use to combat the negative effects of tariffs, and therefore has
the ability to play a “long game.” I concur with former US National Economic
Council Director Gary Cohn, who has asserted that the US can’t win a trade war
with China.5 And so I believe there is a small but growing chance,
depending on how significant the stock market sell-off becomes, that the US may
capitulate in the near term and take minor concessions in order to achieve a
trade deal. If not, then I expect the Fed will clearly feel compelled to act — what
started as a mid-cycle “adjustment” could become a more significant attempt to
bolster the US economy.

In the meantime, I expect continued volatility among a wide array
of risk asset classes — and a continued move to “safe haven” asset classes.

Trade concerns are spreading

Trade concerns are not limited to the US and
China. As I have said before, tariffs are like bacteria in a petri dish — they spread rapidly.

We have a very serious trade situation developing
between Japan and South Korea, in which Japan removed South Korea from most
favored trading partner status, setting up a scenario where South Korea is very
likely to retaliate.

And then there is last week’s US-European Union (EU)
trade deal — a minor trade deal to sell more US beef to Europe. But don’t
expect this to mean that the US and EU will be able to avoid a significant
trade dispute — in fact, a tariff war seems likely. As Trump explained, “The EU
has tremendous barriers to us. They’re very, very difficult.”6 Trump
made it clear that auto tariffs remain an option: “Auto tariffs are never off
the table. If I don’t get what we want, I’ll put on tariffs.”6 The
EU struck a conciliatory tone, indicating it would like to work with the US to
reform the World Trade Organization and address other trade issues, but was
clear that it would retaliate if the US were to apply auto tariffs.

does this mean for investors?

I have been sounding the alarm on trade wars and
de-globalization since 2017. I even mentioned in this blog back in 2018 that
the words, “trade wars are good and easy to win” were the most frightening
words to be uttered that year. And, of course, I stand by that statement.

But what does this mean for investors? We could see the
stock market sell-off continue for days and even weeks. But we have to
recognize that the volatility we are currently experiencing creates
opportunities for selective, discerning investors. Stocks are “on sale” — and US mortgage rates may be moving
lower too.

Further, I believe the more severe a market sell-off, the
more likely the US is to act in some way to counteract the effects of tariffs. I
hold out hope that the US will recognize that winning a trade war with China is
very unlikely; that should prompt it to abandon its masochistic bent and avoid
any more self-inflicted damage. That could mean the US capitulating and
accepting a deal with only minor concessions from China. After all, the US
could always choose to address its grievances with China through the World
Trade Organization. If not, it could mean the Fed turning on the monetary
policy accommodation spigot. Either scenario could be positive for risk assets.

A few weeks ago, I handed the reins of my blog over to my
colleague Brian Levitt, who cautioned
investors to be wary
of their natural instincts to run
from their market fears. Now is an important time to reiterate that. I believe
that the current situation warrants cautious observation — not running. And I can’t
stress enough the importance of staying invested and well-diversified for those
with longer-term time horizons.

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Hooper’s Weekly Market Compass posts in your inbox.
Simply choose “Market & Economic” when you sign up.

1 Source: Reuters, “U.S. economy slows in second quarter;
weak business investment a red flag,” July 25, 2019

2 Source: USA Today, “Trump’s latest Chinese tariffs: What
we know so far,” Aug. 2, 2019

3 Source: Fortune, “China Vows to Respond to New Tariffs
Threatened by Trump,” Aug. 2, 2019

4 Source: MarketWatch, “China’s yuan falls below key level
with U.S. dollar,” Aug. 5, 2019

5 Source: CNBC, “Gary Cohn: Trump’s trade war with China is
hurting the US economy more,” Aug. 1, 2019

6 Source: Reuters, “Trump says auto tariffs never off the
table in EU trade talks,” Aug. 2, 2019


Blog header
image: Hongmei Zhao/

Diversification does not
guarantee a profit or eliminate the risk of loss.

Risk assets are
generally described as any financial security or instrument, such as equities,
commodities, high-yield bonds, and other financial products that carry risk and
are likely to fluctuate in price.

Safe havens are investments
that are expected to hold or increase their value in volatile markets.

A basis point is one hundredth
of a percentage point.

The opinions
referenced above are those of Kristina Hooper as of Aug. 5, 2019. These
comments should not be construed as recommendations, but as an illustration of
broader themes. Forward-looking statements are not guarantees of future
results. They involve risks, uncertainties and assumptions; there can be no
assurance that actual results will not differ materially from expectations.

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