The moves made by China last week should not be a surprise...
Last Friday President Trump seemed to come out of nowhere with one of his famous Tweets saying he would impose the pending tariffs on China starting at 12:01am Friday May 10. This caused markets to react negatively as it seemed President Trump was going rogue. Markets opened down on Monday almost 400 points and then rebounded by the end of the day recovering most of its loss. Yesterday we were not so lucky and the market sold off on the worries of no China trade deal. So what do we make of the Presidents Tweet?
It seems that on Friday the U.S received a notice from China that basically was reneging on most all of the important trade agreements made on paper between the two parties thus far. To some this seems like it was out of left field, and if it was anyone else we would agree. However, we are dealing with China and this is exactly how they negotiate. Anyone who has negotiated a business deal with the Chinese knows that they are very well known to change the deal in the 11th hour to better suit their needs. They will even go to great lengths to try and frustrate their negotiating partners and wear them down all in the pursuit of what they deem to be the best deal For China. This negotiating style goes back centuries and there is not much anyone can do to try and change this behavior.
President Trump knows how to negotiate with the Chinese. The reason he sent the Tweet he did last week was to let the Chinese know they can negotiate the way they want to and that we will do the same. The fact that the Chinese said they would not negotiate with a gun to their head but are still sending negotiators to Washington this week is a sign that President Trump may have called their bluff. We will have to see how this works out, but our view is that as long as they are still talking, a deal should be able to be worked out. A comprehensive deal would be beneficial for both sides, but we do not think President Trump will settle on a deal that is not in our best interest.
We have heard the view expressed recently that a trade fight between the U.S. & China is acceptable now because U.S. growth is solid (3.2% real GDP in 1Q) and inflation is low. We acknowledge the U.S. economy is in good shape. We also acknowledge inflation has been low. However, there are still numerous reasons global trade disruptions are troublesome, particularly now:
1) While U.S. growth has been solid, some of the 1Q boost came from inventories (+0.7% points) which should be paid back in future quarters. Global growth has also been more lackluster.
2) A key fear at the end of 2018 was the Fed would over-tighten against this global backdrop, which has been alleviated by the FOMC pause in 2019. We are just starting to see the positive effects of this monetary policy pause, which affects the economy with a lag. Another market hiccup now would tighten financial conditions, with a Fed that is reluctant to go any further and ease (pause yes, ease no).
3) While inflation has been low, there are still signs it is not dead (rising capacity utilization, rising wages, slowing supplier delivery times). The bond market is not providing a lot of cushion against even a small amount of inflation, with the 10-year Treasury yield at 2.5%.
4) U.S. bank lending standards, while still expansionary, do not look particularly easy. This is a leading indicator for payroll employment. The household employment survey has also been weaker than the payroll survey the past 3 months. Proprietor’s income has also been in a slowing trend.
5) U.S. manufacturing employment has already started to slow, and U.S. mfg PMI measures are still in a downtrend (following global weakness last year).
6) The U.S. budget deficit is large for an economy at full employment (e.g., the unemployment rate at 3.6%). This is manageable if we see capital spending rise, that capital spending boosts productivity, and that productivity pays for higher wages. But CEOs/CFOs seem to be reluctant to start this process (e.g., do the capex) without some clarity on trade policy.