In this scenario, the short-term resolution of the trade dispute should allow continued strong global growth for the rest of 2018 and a renewed upswing in global equity markets, in our view. However, the global economy would not receive an additional boost from Chinese reforms and the trade dispute would likely be resumed sometime in 2019.
The Pessimistic Case
The primary risk to these optimistic scenarios, in our view, is the potential that President Trump may be seeking the far more sweeping concessions that President Reagan extracted from Japan in the 1980s. Robert Lighthizer, President Trump’s trade representative, was one of President Reagan’s lead negotiators with Japan. We believe such sweeping concessions are unlikely because, unlike Japan, China is not an ally of the US and is not dependent on the US for its defense. Furthermore, China believes that the concessions Japan granted to the US in the 1980s were a primary cause of Japanese stagnation that began in the 1990s (we disagree but our opinion does not count).
China’s leadership has already signaled how they will respond if they feel China is being pushed too hard to make trade concessions. Several Chinese officials (with the notable exception of President Xi) have indicated that China will not negotiate with the threat of tariffs hanging over its head. In fact, China’s state-run media asserted that Xi’s proposals were not concessions made in response to threats, but rather were initiatives that China already intended to implement. If President Trump pushes too hard for additional concessions, Chinese leadership could dig in on a principle of not negotiating while being threatened with tariffs. That could leave President Trump facing a choice between a humiliating retreat from his tariff threats or an outright trade war.
Should a trade war erupt, the Trump administration’s current tariff proposals apply to $150 billion in Chinese imports. That exceeds total US exports to China, so any Chinese retaliation may have to venture into the dangerous ground of threatening to sell their vast Treasury bond holdings or explicit retaliation against the Chinese operations of US companies. Both equity and fixed income markets could suffer significant price declines as a result, in our view, which could cost Republicans and President Trump dearly in the midterm elections. It is important to note that if China sells its Treasury holdings, their currency is likely to appreciate as they sell dollar assets and repatriate the money into yuan. A rising yuan could put further downward pressure on Chinese exports.
Risk Management
We believe markets are poised for significant upside if Trump’s aggressive strategy results in potentially meaningful reform of China’s trade policies. However, the consequences for corporate earnings and global growth could be dire should the current dispute spiral into a trade war, in our view. Financial markets have been bounced around by every angry tweet and every signal of potential compromise. An environment with a high probability of a binary outcome (either very good or very bad) significantly complicates our risk management strategy.
We are implementing a multi-faceted approach to deal with the complexity of the possible outcomes. In our shorter time horizon portfolios, those portfolios with horizons less than 7 years, we will likely reduce equity exposure in the portfolios if our stop loss level is breached. This approach should help mitigate drawdowns in these portfolios. We believe that our longer time horizon portfolios can endure greater volatility and therefore we intend to maintain our current equity exposure in these portfolios if our initial stop loss is breached. However, we have set a lower stop loss for these portfolios in case our pessimistic scenario becomes increasingly likely. Views and opinions are as of the date published and subject to change.
Conclusion
In his book The Art of the Deal, President Trump describes his negotiating style as an initial series of unreasonable demands and heated rhetoric followed by unexpected compromises. He appeared to follow this pattern in his dealings with North Korea, in his proposed steel and aluminum tariffs, and in his sudden decision to reconsider US participation in the Trans Pacific Partnership. China has offered significant concessions that, if accepted, can be marketed as a big triumph for the Trump administration’s aggressive approach to trade disputes. President Trump’s track record thus far in office suggests that he will compromise quickly once he thinks he has achieved all he can achieve. Given the concessions China has put on the table, we believe the odds have significantly increased for a compromise solution offering at least the potential that China opens its markets to more foreign goods and services.
Market volatility will not end if we see a positive resolution to the China trade dispute, in our view. Our 2018 Outlook contended that markets will experience higher levels of volatility for the foreseeable future. Fed interest rate hikes along with continued political drama should provide plenty of opportunity for markets to become unsettled. However, we believe that a positive resolution to the current trade dispute could eliminate the primary risk to the global economy and allow continued strong earnings growth to push global equity market higher despite continued volatility.
Michael Jones, CFA, is Chairman, President and CEO, RiverShares Division, and Kevin Nicholson Chief Market Strategist, COO, RiverShares Division, at RiverFront Investment Group, a participant in the ETF Strategist Channel.