Fears of a US-China trade war are stoking market unrest. Which sectors and securities could see the greatest impact?
Volatility now, negotiations to follow -- Jeff Schulze, Investment Strategist, ClearBridge Investments
The Section 301 review of US-China trade announced this week was not on the radar screen for many investors, even though it was a pivotal part of the Trump campaign. This activity could in principle lead to several outcomes, including additional tariffs, limits on Chinese investment into the U.S., restrictions on the ability of Chinese companies to do business in the U.S. and limiting visas to Chinese citizens.
Although the U.S. imports far more from China than it exports (a negative trade balance), more U.S. companies would be hurt by a trade war than helped. Industries most negatively impacted include aircraft, autos, agriculture, semiconductors, and chemicals. Industries that would be most positively impacted include steel, aluminum, telecommunications equipment, furniture, and textiles.
Currently, there has been discussion of 25% tariffs on products in the specific areas of aerospace, information and communication technology, and machinery. With a more limited scope of tariffs being discussed and policymakers having hopefully learned the lessons of the past, we believe that a compromise agreement will be reached rather than a trade war breaking out.
Section 301 has been utilized in the past, with three reviews of Japanese trade practices from 1985-1995 which targeted semiconductors, electronics, and autos. In fact, there are parallels between Japan’s past trade relationship with the U.S. and China’s today: at its peak, Japan accounted for close to 60% of the U.S. trade deficit, while China currently accounts for close to half.
In our view, the objective here is not imposing tariffs, but rather to increase leverage in negotiations. Most of these historical 301 reviews, including several in the 1990s and 2010 involving China, led to new trade agreements rather than the establishment of tariffs. An often-overlooked aspect of this issue is that in the past the U.S. and China have shown a willingness to negotiate: it’s worth noting that during Trump’s visit in 2017, China announced it would open up its financial services sector in the medium term, coupled with trade agreements worth $250 billion.
This is not to say the market won’t have anxiety about the U.S.-China relationship in the near term. The tariffs are subject to a 30-day comment period from the day of the announcement on March 22, a fluid situation as the specific product categories targeted and overall tariff levels will likely change.
Alternatively, the potential exists for an agreement to be forged between U.S. and Chinese policymakers, similar to what has happened in the past. Investors, however, do not like uncertainty and the market may see additional volatility as these events play out. Ultimately, we believe volatility emanating from these issues represent a buying opportunity for longer-term investors.
A boon for emerging markets? - Kim Catechis, Head of Emerging Markets, Martin Currie
China’s modest response to US tariffs on steel and aluminum imports and proposed charges on up to US$60 billion of Chinese products has been to target mainly agricultural goods. However, there are further measures available to China that could be deployed in the event of any further escalation.
While these headlines may have caused alarm among investors in emerging markets, in the longer term, we believe these trade restrictions will only serve to accelerate the rapid growth of intra-regional trade among emerging markets to the exclusion of the US. In our view, this will further shift the gravitational axis of world trade in emerging markets’ favor.
The point is that the threat of $60bn further tariffs is not unexpected, and the Chinese have a long list of proportional tariffs available to them with which to respond.
Varied impact on stocks -- QS Investors
While we entered 2018 with a positive outlook for equity markets and global economic growth, several risks were already apparent early on. These risks include valuations, which continue to be well above historical means; the economic expansion in the US reaching its later stages; rising interest rates as developed central banks tighten their monetary policy; and political uncertainty, both domestically (budget gridlock) as well geopolitically (US trade policy).
Concerns about US trade policy materialized yesterday with the US President’s announcement of new tariffs on a wide range of Chinese consumer products and China’s response in kind, inciting “trade wars” fears. Equity markets sold off on the news, as expected.
The most direct impact of trade tariffs will likely be a slowing down of global trade activity, with negative consequences on global economic growth. Global trade is a core component of our index measuring leading economic indicators, which in turn informs our global stocks versus bonds decision. QS currently holds a neutral short-term view on stocks relative to bonds, so a decline in global trade activity could further dampen our view.
In addition, yesterday’s news, and the potential for escalation of this conflict, increased uncertainty in financial markets, causing a spike in volatility and the decline in major equity indices and other risk assets. Rising volatility often presents a challenging environment for high yield bonds, should market volatility continue to increase it could further strengthen our preference for US investment grade bonds over US high yield bonds. However, the impact of a potential trade war with China will not be uniform across geographies, sectors and themes within equity markets. For example, we expect companies in cyclical sectors (such as technology and industrials) to suffer the brunt of the impact, we expect stocks deriving a large portion of their revenue from abroad the US to suffer more than domestically oriented companies, and we expect more volatile stocks to underperform stocks with more stable price and earnings.
Such market environments call for equity investors to be more selective in their equity allocations. Positioning for uncertainty and potential opportunities in a lower economic growth environment requires moving away from broad equity exposure and into a more focused and targeted approach. We expect defensive equity income stocks (stocks that exhibit lower volatility than the market and offer sustainable dividends) to outperform when markets are volatile, as sustainable dividends become a larger contributor to total returns in a low growth market environment. With higher exposure to non-cyclical sectors, such as utilities and REITs, we expect defensive equity income stocks to suffer less of an impact from yesterday’s tariff announcements.
Fixed Income: Impact on US Treasuries -- Western Asset
While some have questioned whether selling U.S. Treasuries could be on China’s list of potential retaliatory measures, counter-tariffs on US imports have the benefit of being more targeted and easier to control. In addition, selling Treasuries today (and buying assets denominated in their currency with the proceeds) risks an appreciation of China’s currency.
Treasuries have been one of the most reliably diversifying assets for investors’ portfolios. We think they will continue to fill that important role. If the U.S./China trade war escalates, that could pose material risks to growth and markets. In that case, we would expect Treasuries yields to fall as the demand for safe assets rises. For that reason, owning Treasuries continues to be part of our portfolios.
The popular thesis that tariffs will lead to inflation is wrong for three reasons. First, higher tariffs would cause a one-time increase in the price level. But, inflation is, by definition, an ongoing process, so a one-time shock doesn’t increase inflation, unless it is repeated on an ongoing basis. Second, higher prices are likely to weigh on demand, potentially leading to slower growth and inflation going forward. Finally, restrictions on international trade could pose significant challenges for many companies with global supply chains, not to mention countries dependent on exports, which would further weigh on global growth and inflation. Given the high level of interlinkages in the world economy and financial markets, the U.S. could be negatively affected by these challenges.