The June Market Pulse

Tilney Group’s Chief Investment Officer Chris Godding discusses the macroeconomic ideas and research from June 2019.

Huawei: a microcosm of the trade war

Ren Zhengfei, founder of Huawei, recently announced that the Chinese telecom giant’s revenue will be US$30 billion less than forecast over the next two years due to US government sanctions.

This announcement follows Huawei being placed on the US entity list which effectively bars US companies from selling components or software to Huawei without government approval and makes it the most visible victim of the impact of the ongoing trade dispute between China and the US.

In technology circles, Huawei is considered to be one of the most important contributors to the development of international standards in 5G; restricting the industry from free access to their patents will further highlight that everyone loses in a trade war.

China – the US’s largest trading partner

China is the US’s largest trading partner, with a total of US$737 billion in goods and services traded in 2018. While the trade deficit in goods was US$420 billion, the trade surplus in services was US$40 billion and the Department of Commerce estimates that US$180 billion of US goods and services exported to China support nearly a million jobs in the US.

So far, the US has imposed tariffs on US$250 billion worth of Chinese products, and has threatened tariffs on US$325 billion more in order to bring manufacturing home. China has retaliated proportionately so far and the world is now waiting – and hoping – for a solution.

The global supply chain has been fundamentally remodelled since China began liberalising trade in the late 1980s and joined the World Trade Organisation in 2001. Many US companies that use China for re-export or manufacturing are already reorganising in reaction to the current tariffs, and further escalation has the potential to become a watershed moment for the global economy.

Ceasefire on US-Mexico tariffs

Despite the trade dispute, global equity markets have proven remarkably resilient, thanks to the ‘Powell put’ and a ceasefire on trade tariffs with Mexico. Markets are now expecting Jerome Powell, chair of the Federal Reserve (Fed), to come to the aid of the flagging global economy and pivot the Board into a cut in interest rates in July.

Donald Trump has also backed away from escalating tariffs on Mexico, which many investors read as an indicator of what he might do with China. However, Mexico is a very different situation compared to the deteriorating strategic relationship with China post President Obama, who won a Nobel Peace Prize for achievements through cooperation with countries such as China on key global issues, including climate change, nuclear security and cyber warfare.

Contain or assimilate

The approach of the current administration places less emphasis on assimilation in favour of the secondary Obama strategy of containing China’s growth and ‘rebalancing [the United States] to the Asia-Pacific’.  This is an approach that Beijing clearly regards as provocative. Subsequently, the reaction to trade negotiations in China is rapidly becoming more hardline and it would be naïve to assume that China will back off and play ball.

The US has many valid issues with regard to China’s anti-competitive behaviour and intellectual property theft, but no one likes a bully, particularly an intensely proud, powerful and self-reliant communist state whose stability depends on the perception of invulnerability.

What will happen next?

Finding a way forward requires an outstanding statesperson with vision and leadership. Unfortunately Xi Jinping is too focused on the preservation of the Chinese Communist party to fulfil that role and there are no obvious candidates on the other side. Where are Madeleine Albright or Condoleezza Rice when you need them?

At the time of writing, deferral of the next stage of tariffs appears to be the best we can expect in order to buy time for a trade deal to be worked out. Investors will probably see this in a positive light but we can’t have our cake and eat it.

A quick resolution on trade may well defer the Fed from cutting rates in July, as they are naturally wary of overheating a domestic economy at full employment and where the consumer is in very good health. Real wage growth in the US, and the UK as it happens, is relatively strong and consumption is doing a good job of compensating for any weakness on the investment front.

Real Wage Growth (Year on Year) Recovering

Preference for a trade deal over a rate cut

At the current juncture, a trade deal and a recovery in global growth is preferable to a cut to US interest rates. The rate cut would be a reaction to an expectation of a significant slowdown in activity, potentially stagflation, while the recent market rally we have seen, based on lower rates, would be vulnerable.

A continuation of the trade war would feed through to inflation or lower margins, undermining earnings or valuations – or both. Even if the US were able to miraculously create the manufacturing capacity required to substitute imports with domestic goods, current immigration policy means that the labour force is simply not available to man it. Wages and inflation would skyrocket and interest rates would follow suit.

The global economy

While we patiently wait for the outcome of the stand-off, Dario Perkins at TS Lombard notes that “there is nothing in the data to suggest an imminent re-acceleration of the world economy. Manufacturing data have deteriorated further, with the global PMI dipping below 50 – its lowest levels since 2016. World trade is also getting weaker, with the classic bellwether economies of South Korea, Taiwan and Sweden showing continued contraction, rather than the start of a convincing recovery.”

Fiscal and monetary stimulus in China is being offset by the slowdown in world trade. Morgan Stanley’s business conditions index in the US fell 32 points in June, the largest drop on record, and the lowest reading since 2008 and collateral damage is spreading to Europe and Japan.

Europe has had the luxury of the largest trade surplus in its history, thanks to weak domestic demand. Japan’s industrial base is sensitive to global growth. Monetary policy is losing its potency to solve the structural problems and Japan and Europe both need a trade deal soon.

Industrial Production (%Year on Year*) – Japan and Europe need a deal

The next president of the European Central Bank

From a political perspective, Europe is contemplating a transition of the two highest seats of power. Mario Draghi and Jean-Claude Junker are leaving their posts at the end of October and the choice of their successors is already the subject of intense lobbying.

Draghi’s replacement is of paramount importance since, as Cedric Gemehl at Gavekal notes, “his successor must be similarly eloquent, but also politically cunning if he or she is to persuade Europe’s leaders that monetary policy is reaching its limits, and fiscal policy must take the strain.”

Bundesbank president Jens Weidmann is one of the front runners for the job. He is a well-known critic of the European Central Bank’s (ECB’s) unconventional policies under Draghi, and the ‘whatever it takes’ Draghi put option could expire with Weidmann’s appointment. However, these tools are now so embedded in the ECB’s infrastructure that they would be hard to discard and, while the president has a key role, so does the newly appointed chief economist Philip Lane, who is firmly aligned with Draghi’s policies. Weidmann’s influence would be diluted by Lane, but will still be more hawkish.

Weidmann would be a more of a shoo-in if his German compatriot Manfred Weber is not appointed President of the European Commission, as Berlin is likely to demand some representation in one of the two roles despite significant over-representation at principle EU financial institutions already. Weidmann’s appointment will also do little for gender diversification since the only German on the ECB executive board is a woman, who would have to resign.

The remaining candidates are Erkki Liikanen and Ollie Rehn from Finland and Francois Villeroy de Galhau and Benoit Cœuré from France.

The ECB president is in probably one of, if not the most powerful positions in Europe and will directly impact markets. Whoever is appointed faces four challenging years of maintaining some form of equilibrium and reform under the intense scrutiny of investors. Draghi’s recent speech at Sintra hinted that the next president would have to follow in his footsteps, which does not bode well for Weidmann. The markets have rallied strongly on the hint of another dove in charge at the ECB and although Cœuré is a strong Draghi supporter, my best guess for the crown would be Ollie Rehn.

Our portfolio strategy

I return now to the immediate future and our portfolio strategy. A collapse in the trade negotiations and a Fed rate cut would challenge our assumptions for earnings growth over the coming year and we would be more likely to cut our equity weighting tactically. If the proposed increases in tariffs were delayed to allow for talks to continue, the Fed would provide support with an interest rate cut in July and we are more likely to hold onto our current weightings and positive outlook.

A Fed rate cut, plus a relatively quick resolution to the trade dispute is also a low but not insignificant probability to contemplate. In this scenario we would be tempted to increase our equity weight materially. It would light a fire under markets and cyclically sensitive sectors in particular. If this transpired, we would also reconsider our exposure to growth managers over value managers in the portfolios.

MSCI World Growth versus MSCI World Value

The chart above shows the performance of the MSCI growth index relative to the performance of the value index. The growth index has a bias to companies delivering above-average sales and profits growth over time, while the value index has more exposure to companies with high operating leverage and financials that do well when the global economy is strong. Value stocks also tend to do well compared to growth in periods when inflation and interest rates are rising but not choking off the recovery.

The market expectation for growth is represented in the chart above by the spread between 2-year and 10-year interest rates in the US, which is higher when the economy is expected to grow rapidly and smaller or negative when a recession is likely. Since the end of 2013, growth stocks have done substantially better than value stocks as this 2-10 spread has declined. Growth has been harder to find and with interest rates falling, any growth stock is that much more valuable to investors based on the present value of future cash flows. In the US in particular, the performance differential between growth and value is quite extreme, with growth beating value by 118% since 2009.

Many of our favoured investment funds have done very well by assuming a growth bias. The managers correctly spotted the increasing value of a steady or growing stream of income in a world dominated by debt and deflation and have materially outperformed their benchmarks as a result.

Now, after 10 years of outperformance, the growth darlings are very well-known. They are widely held and we are sensitive to the fact that this is a crowded trade. Therefore, if the Fed does cut interest rates and China reaches a trade deal with the US, the shift to economically sensitive value sectors could be quite significant. We have done the groundwork to rebalance the portfolios if required but, in our view, the probability of this type of policy mistake and ‘melt-up’ scenario looks relatively low. For now, the structural debt and deflation theme that favours growth has not changed.

For more information or if you have any questions, please get in touch by calling 020 7189 2400.

Important information

Chart sources: Bloomberg. 

*3-month moving average data.

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