Game of Unknowns

Like some of the horrific plot twists in the sensational “Game of Thrones” HBO series, sudden changes to our reality can leave us in a state of shock. These twists can decimate the established storyline and create uncertainty about what might come next.

Sometimes that twist takes the form of an old, forgotten villain’s unexpected return to the tale. Like J.R.R. Tolkien’s Lord of the Rings villain Sauron, a somewhat overlooked evil is once again rising in our reality in the form of the resumption of trade tensions between the U.S. and China. While the China - U.S. trade news has been market-moving lately, it alone does not determine the fate of the global economy and we should not let it run away with our imaginations.

A Twitter-Worthy Executive Summary

While trade tensions with China have flared up once again, it remains in both countries’ interest to come to a mutually agreeable outcome. Uncertainty about the timing and structure of a future deal will likely result in continued bouts of market volatility, which may also create investment opportunity.

The Tweet Heard Around the World

The trade conflict between the U.S. and China (along with other parts of the world) has been a simmering issue since January 2018. Since that time, markets have largely taken the trade conflict in stride, quickly brushing off short-term losses caused by related headlines or Twitter posts by President Donald Trump (which we have been jokingly referring to as “Twitter-risk”). For example, the most recent flare-up in trade tensions came as a result of his tweet on May 5, 2019, which threatened to raise tariff rates on Chinese goods from 10% to 25%. 

Source: Twitter.

As of Friday May 10, the United States officially followed through by raising the tariff rates on $200 billion of Chinese imports, while simultaneously threatening to broaden the application of tariffs to other Chinese goods. The full impact of this change will likely not be felt for a few weeks as the hike will not affect goods already in transit from China. It remains to be seen entirely how China may retaliate with its own policies and if the United States will indeed institute larger and/or more broadly issued tariffs on Chinese goods in the future. As it stands, the current tariff levels plus the May 10 increase (yellow portion in the chart below) have increased tariff levels well above other developed nations, and on par with emerging market countries. The addition of the other threatened tariff increases (green bar in chart below) from Trump’s May 5 tweets would create nearly the highest tariff policy of all of the major world economies if implemented fully.

Source: Slok, T. (May 6, 2019). Quantifying the Trade War. Deutsche Bank.

In comparison to the United States’ own history, full implementation of the proposed trade taxes would return tariffs — as a percentage of GDP — to levels not seen since the 1930s. One might suggest that the last 100 years or so represented a fairly good economic timeframe for the country, and imposing trade restrictions via taxation could be counterproductive. Economic historians have theorized that trade protectionism, via policies like tariffs, is largely responsible for causing the Great Depression. That theory makes the current situation and escalation scenarios worrisome for investors.

Source: Root, A. (May 10, 2019). U.S. Tariffs Haven’t Been This High Since the Great Depression. Barron’s.

Based on the above data, it is not surprising that investors’ polls are showing the highest level of global government policy uncertainty on record. Uncertainty about anything that has a significant potential impact on investment markets is a recipe for price volatility, which is exactly what has been delivered by markets so far in May – reportedly the worst May market performance in almost 50 years¹.  

Source: Market Know-How, 2nd Ed. (2019).  GSAM

As of this writing, the S&P 500 stock index was still positive from the 2018 breakout of the supposed “trade war.” Obviously, that is not the outcome put forth by the fear-mongering prognosticators that have been predicting economic calamity and a stock market collapse over the last year-and-a-half. That statement is not meant to suggest that the ongoing dispute will not cause price swings; it absolutely has and will likely continue to do so, following the below tongue-in-cheek event cycle, until a final deal is reached.

Why It is in Everyone’s Interest to Get Along

Your CWM team remains convinced that a future trade deal is an inevitability, though we do expect the cyclical gamesmanship to continue in the negotiation process for some time yet. It is your CWM team’s belief that it’s in both countries’ economic interest to get along for a variety of reasons. For instance, it is in China’s interest because the United States has the wealthiest consumer class in the world. U.S. consumer spending by itself is the world’s largest economy, and obviously China would like to have that spending go toward the purchase of Chinese goods, rather than products from competitors that don’t suffer from artificial price inflation thanks to tariff policy.

Source: Torsten, S. (April 2019). Global Economic Outlook: Near-term Rebound Likely; Outlook for 2020 More Worrying. Deutsche Bank.

On the other hand, the U.S. also has an interest in compromising if it wants to continue being a major player in global trade. Of the top 50 container ports (read as “centers of global product distribution”), over 40% are located in China and another ~30% reside in nearby countries over which China likely has some influence. The port of Shanghai alone moves more volume than any of the five largest U.S. ports. It is also worth noting that the country also contains ~18% of the global population. To be a player in the global trade game, it would likely not be beneficial to alienate or antagonize a competitor with such large control of the game board and its pieces.

Source: Routley, N. (January 14, 2019). Visualizing the World’s Busiest Ports.  Visual Capitalist.

On a bit of a side note, China is also Washington State’s main foreign import and export partner, which makes this a more important issue for the home state of CWM and the majority of our clients. The state could suffer an estimated 1.5% hit to state GDP in a worst case scenario.² A continued trade conflict will have a greater impact at certain local levels.

In your CWM team’s opinion, the result of all this is likely higher market volatility, but not a meaningful change to the longer-term outlook for investment markets. Even if significant near-term market weakness (significant being a 10 to 20% market sell-off) were to occur, it would likely be an opportunity, in our opinion, and not a substantial future threat unless the trade war tragically turned into a shooting war (a very low probability event at this point in time). It may be that the continued trade conflict, and the investor fear it induces, will create a buy-on-sale opportunity for prudent investors. If so, this would likely allow for investors to confidently take an aggressive investment position, similar to the actions seen in all CWM client portfolios during the fall 2018 market sell-off.

The Current CWM Outlook

While we view the China-U.S. trade dust-up as at least partly responsible for recent market volatility, it’s important to keep in mind that the domestic U.S. stock market has also had one of the best starts to any year since World War II. If nothing else, active market participants were likely looking for a reason to take some profit off the table, and President Trump’s aggressive tweets provided the catalyst for that action. The current S&P 500 drawdown (as of May 13) is less than 5% from the high set earlier in the month. As the table below shows, market drawdowns, especially small ones like we just witnessed, are a regular feature of a normally functioning stock marketplace. Going back to 1928, a 5% sell-off occurs more than three times per year on average. If the current “trade war” induced sell-off hits that mark, it will only be the first time this year.

Source: Rossi, P. (May 2, 2019). How frequent are market dips, corrections, and bear markets? @rossifg Twitter.

Because of near all-time high measures of valuations and potential fallout from the ongoing trade negotiations, your CWM team has elected to maintain a sizeable position, and slight overweight, in very conservative investment categories like U.S. treasury bonds. These assets are unexciting during sharp market rallies, but they also historically provide a significant buffer during times of market turmoil—a protective purpose they have served well throughout May. As markets sell off and make valuations more reasonable, it is starting to look a bit more favorable for stock investments, and we may consider moving more portfolio exposure away from protective positions and into typically more aggressive stock positions. Below are the current CWM data quadrants with basic interpretations (green = good, red = bad) along with our current projection ranges for stocks and treasuries based on those inputs.

Source: Two-Year Asset Intervals. (May 8, 2019). CWM. Intercontinental Exchange. Yahoo! Finance.

Please pass this article on to anyone you know who may be interested in or might benefit from the information. We are always looking for more great clients and would welcome any opportunity to assist them.

If you have questions or comments about the above subjects or other investment topics, I would love to have a conversation! Feel free to email me or, if you are interested in more regular financial tidbits, follow me on Twitter @MorganArford.

Morgan Arford
Chief Investment Officer

P.S. Behold! The power of compounding and investing early! At an assumed rate of 8% return per year, a person that saves and invests $3k per year from age 21 until age 30, where they stop investing new funds, will have more money by age 70 than someone who starts that same savings rate from age 30 -70.

Source: Compounding Interest: The 8th Wonder of the World. (May 10, 2019). LPL Research.

References:

¹ Decambre, M. (May 13, 2019). Dow, S&P 500 Set for Worst May Tumble in Nearly 50 Years Amid U.A.-China Trade Clash. MarketWatch.
² Slok, T. (May 9, 2019). Trade War Charts. Deutsche Bank.

This article has been prepared and distributed for informational purposes only and is not a solicitation or an offer to buy any security or investment or to participate in any trading strategy. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice as individual situations will vary. For specific advice about your situation, please consult with a financial professional. Past performance is no guarantee of future results.