• Doug Lagerstrom

Market Outlook | Summer 2019

The overall US economy continues to be strong even as the global economy trudges through economic malaise. US unemployment is lower than it has been for 50 years, worker productivity is up to 2.4%, as of the first quarter, and US GDP averaged just over 3% for the past year. So, we have low interest rates and a booming economy. What’s there to worry about? In a word, trade.

It is widely accepted that China has been violating our intellectual property rights law for years. One doesn’t need to be in China for long to find bootlegged movies that have just been released, for example. There appears to be bipartisan support in the financial community to deal with this long-standing issue. According to Jason DeServa Tremmert, CEO of Stregas Research Partners, “There was a bipartisan feeling (among his institutional clients) that standing up to China was a fight worth having to protect national security and economic interests of the United States.”

What is the best approach?

It’s not a stretch to say our current President seems to relish in conflict. While traditional politicians look to compromise, President Trump likes to antagonize his opponents. Robert Lighthizer, the lead US trade negotiator with China, shares our leader’s desire for confrontation. One sticking point in the negotiations is that Lighthizer seems to be requiring a “legally binding agreement” so the Chinese can’t cheat.

Therefore, it’s not surprising that, although a trade deal is in both countries’ best interest, China and the US are posturing for a prolonged conflict. Although China has more to lose in a trade war than the US, they may be taking the long view of figuring the can respond to a slowing domestic economy with weak monetary policy in the event of a prolonged trade conflict.

Although many commentators are quick to point out that the Chinese take the long view and Trump will be subject to political pressure to strike a deal as he seeks re-election next year, they don’t often point out the leverage the US has in these negotiations.

Let’s look at some now:

- Millions of Chinese citizens work for US companies, directly or indirectly.

- Our economy is $21 trillion and even the $500 billion in Chinese exports that could be at risk is relatively small

- Huawei, a major Chinese telecommunications company, desperately wants access to the budding US 5G market.

- Lastly, the timing of a war, if you’re going to have one, is good. “If you were ever going to impose costs on the U.S. consumer, the time is when unemployment is at 50-year lows and inflation is a pancake,” according to Christopher Smart of Barings Investment Institute.

There is also an issue of the trade imbalance between our two countries. There is certainly less consensus on the view that this issue necessitates a trade war. For starters, China may be less of a culprit here than Europe. Excess production measures the amount of economic activities generated domestically, minus the amount consumed in a country. Since 2013, Europe’s total excess has been larger than China’s every year. In 2018, Italy alone had a larger imbalance than China!

The reason for this imbalance isn’t cheating on trade or currency manipulation. Simply put, the economy is much worse in Europe than other parts of the world. Since 2008, consumption and investment has fallen in Europe, while exports have risen with global demand. Domestic spending is 7% less than before 2008, and unemployment and poverty are higher. In short, the excess production is not a case of an importing countries problems, but a symptom of the exporter.

It is possible that Lighthizer is trying to negotiate a “Plaza Accord” like deal with the Chinese. For those who don’t know, President Reagan was dealing with a trade imbalance with Japan. The Plaza Accord required Japan to strengthen its currency to allow the US to export more goods (our goods become cheaper to the Japanese if their currency is worth more.) Japan responded by lowering interest rates to stimulate the economy in the face of a slowdown in exports. The result was the great asset bubble in my lifetime.

The Nikkei stock market trades at roughly $21,000. In 1989 it reached a peak of $33,000. In other words, if you invested $33,000 in the Japanese total stock market in 1989, you would have $21,000 today. 30 years later! There are reasons that the Chinese won’t face a similar fate.

- Japan’s currency floated and China controls the yuan.

- China has $1.1 trillion in US treasuries

- Beijing may depreciate their currency, but not to a level that destabilized the economy

We are likely to ultimately get a deal since it is in both leader’s interest to complete one. President Xi, although not facing an election, does face some pressure from the Chinese middle class. Huawei also needs US microchips. By blocking access to that import, President Trump has increased his leverage. President Trump is, of course, up for re-election in 2020.

If you’ve been paying attention to his tweets, you know he watches the stock market and appears to grade his presidency by the performance of the market. He also needs a deal to solidify his self-proclaimed position as a great negotiator, but first ge gas to play tough so he can tell voters this was the best possible deal he could get.

In the meantime, the US investor has a volatile front row seat as this drama plays out.

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