Short and Sharp: A reversal of fortunes could be on the horizon

The U.S. economy grew by 4.1% in the second quarter. While this spells good fortunes for investors short term, this impressive performance may embolden President Trump to double-down on his recent protectionist actions, possibly leading to negative repercussions for the U.S. economy in the longer run.

So far, the trade war has hit Chinese equity markets the hardest. Since April, the S&P 500 Index has strengthened by around 10%. By contrast, China’s equity market has slumped around 20% since the start of the year. In fairness, China is also contending with tougher financial regulations and a slowing economy. Even so, with this kind of relative market performance, why would Trump consider changing his protectionist stance? With the midterm elections fast approaching, it may even make good political sense to escalate it further. The political opportunity, coupled with Trump’s well-documented history of protectionist and anti-trade views, mean that unless there is overwhelming evidence tariffs are hurting the U.S. economy and equity markets, he is unlikely to tone down his approach.

But that may be problematic for the U.S.

Tariffs on China are likely to invite retaliation, with negative impact for the U.S. economy. But U.S. tariffs themselves will inevitably hit some U.S. goods. The nature of complex global supply chains mean that domestically built Chinese goods are likely to have components imported from several countries – including the United States.

Pervading uncertainty and concern about the probable effects of future tariffs and counter tariffs are already being felt as U.S. companies have been discouraged from implementing planned business investments.

Tariffs will also feed through to higher U.S. inflation. So far, the tariffs have focused on the components of production, which tend to slowly work their way into final prices. In the initial set of U.S. tariffs on Chinese imports, less than 5% were consumer goods. But in the second round, that number rises to over 30%, and it will likely be even higher in the latest round. This means the impact on inflation is likely to become more significant.

Perhaps as demand for U.S. agricultural exports falls and consumer goods prices rise Trump’s supporters may start challenging his trade agenda – leading him to second-guess his current approach to China.

Because the U.S. economy will likely emerge less damaged than its targets in this ongoing trade dispute, I currently prefer U.S. equities over international equities – and certainly over Chinese equities. However, following recent declines, valuations for Chinese equities are more attractive. Technicals have turned more positive now that sentiment and positioning have deteriorated. It may simply take a positive catalyst, such as an easing in trade tensions, to trigger a recovery in Asian equities.

Although the costs of protectionism may not yet be visible, the corrosive impact of the trade war will eventually hit the U.S. economy. At that time, I would expect trade measures to be wound down with Asian assets standing ready to reap the benefits. So, despite the current positive narrative for the United States over Asia, 2019 may see a reversal of fortunes.



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