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Schwab Market Perspective: Trade Tension Takes Turn at Top

By Liz Ann Sonders
By Jeffrey Kleintop
By Brad Sorensen
Key Points
  • Rising trade tensions with China have rattled U.S. markets, but other trade issues may be cooling. Volatility is likely to remain elevated until there is more clarity on trade; but it’s increasingly likely this could be a long slog. 

  • Although on the back burner recently, economic data has been mixed and we’re concerned that the longer the trade dispute lingers, the bigger the hit will be to business and consumer confidence. 

  • There may be some international locations that are worth a look in the midst of the trade drama, as some areas may be able to stay out of the fray.


Listen to the latest audio Schwab Market Perspective.


“Guard against the impostures of pretended patriotism.” 
   ― George Washington

We remember

The phrase “trade war” is front-and-center in the news, but this weekend reminds us of the price thousands of American patriots have paid defending freedom in actual wars. We are thankful that we are free to worry about such things as trade, earnings, and market movements, thanks to the courage and bravery of those who have fought and died to keep us free. We remember and honor them, now and always.

Trade takes center stage

With a tweet from the President, trade tensions jumped back to the forefront of investors’ minds, pushing volatility higher and aiding a long-awaited pullback.

Volatility rose as trade tension heated up

VIX short-term

Investors have dealt with a back and forth of rising tariffs from both sides of the U.S.-China trade dispute, with the ball currently in the Americans’ court, as the Trump administration is currently studying whether to raise tariffs on the final and largest tranche of Chinese imports. The near-term impact on the market is easy to see, but determining the longer-term economic impact more difficult. That said, multiple recent studies—including by the National Bureau of Economic Research (NBER) and Goldman Sachs—have basically settled the question of who bears the greatest cost of the tariffs … U.S. companies and their consumers do.  At this stage, our friends at Cornerstone Macro estimate a drag on U.S. GDP of -0.30% based on already-imposed tariffs, with a significant 0.4% additional jump expected if the remaining proposed tariffs on $325 billion of Chinese imports are imposed. 

Those estimates are largely based on the direct impact of Americans paying higher prices (a “tax”) due to the tariffs. We are also concerned about the hit to corporate confidence and the attendant halting of forward capital spending plans. The consumer-led growth part of the economic cycle is already rolling over; and the hoped-for next leg of capital spending growth is being dashed.  For now, despite a modest pullback, business confidence remains fairly high (especially among smaller companies); but most measures haven’t taken the latest rise in trade tensions into account. Already, we’ve seen the ISM Manufacturing Index indicate that manufacturing executives are growing more concerned about the trade uncertainty; with the key leading indicator of new orders in decline. We’ll be watching confidence, and capital spending plans, closely as the trade tensions drag on. 

Corporate confidence dented but remains elevated—for now

NFIB Small Business Optimism Index

What is uncertain at this stage is the more dominant trait of President Trump: retaining his self-proclaimed “tariff man” status at any cost, or the desire for a second term as President? The latter would suggest a lofty incentive to reach a deal; however, there are two sides in this battle, and China is making it increasingly clear they are playing a long game and won’t be “bullied” (their word) into a deal. In the meantime, it’s our job to try to assess the economic and market implications of the tariffs to date, without trying to game or forecast an unknowable outcome. 
The trade news is not all bad. Earlier this month, the Trump administration announced it was delaying a decision on auto and auto parts tariffs, which would have had added the European Union and Japan to the trade battle. Also, according to our own team in Washington, the formerly-NAFTA/currently-USMCA trade agreement among the United States, Canada and Mexico is at least slightly more likely to be ratified by Congress courtesy of the decision to remove tariffs on steel and aluminum aimed at Canada and Mexico.  (For more on trade tensions see Liz Ann’s Street Fightin’ Man: President Trump Ups Trade War Ante article).

Economic data on the back burner, but should not be ignored

With trade taking up much of the oxygen in the room, recent economic data may have been overlooked by many investors. There were some recent releases that added to our concerns about the near-term trajectory of economic growth. First quarter real gross domestic product growth (GDP) was stronger than expected, but boosted significantly by inventories and net trade; both of which are expected to reverse in the second quarter. Since that release, we got the April readings on industrial production and retail sales; which were both big misses, at -0.5% and -0.2% month/month, respectively (see charts below). In addition, according to the Federal Reserve capacity utilization dipped again, moving from 78.5% to 77.9%.

Manufacturing data declining

Industrial Production

And consumers still seem cautious

Retail sales vs retail sales ex-auts MoM bar

There has been positive news as well, with initial jobless claims turning back down after a couple of weeks of higher readings; and regional surveys such as the Empire Manufacturing Index and the Philly Fed Index both posted gains in the latest readings.
Although the data has been a mixed bag, and it’s still early, two well-watched forecasts of GDP—the Atlanta Fed’s GDPNow and the New York Fed’s Nowcast—are sporting 1-handles on expected real GDP growth for the second quarter. The New York Fed also runs a recession probability model based largely off the yield curve, and it is approaching 30%. Although there were exceptions in the late-1960s and late-1990s, a level this high has been a consistent warning of a coming recession.

Fed still supportive

In the midst of all of this the Federal Reserve remains in pause mode; after becoming significantly more dovish since the January Federal Open Market Committee (FOMC) meeting. However, there remains a yawning gap between the market’s expectation of a 90% likelihood of a rate cut by year end and the Fed’s official forecasts, which suggest the next move will be another hike.  We believe economic data would have to deteriorate much more for a rate cut to come to pass near-term—and as usual, the convergence between the market and the Fed could contribute to volatility in the coming months.

Shelters from the Storm?

In general, the markets seem to subscribe to the notion that there are no winners in a trade battle. By staying out of the fight, a country or region may be able to avoid collateral damage. U.S. and Chinese companies may bear the brunt of the costs of their ongoing trade battle. Already, China’s better-than-expected economic data reported in April (surprise index above zero in the chart below) was short lived, as we had expected.

April’s positive economic surprises in China were short-lived

Citi Economic Surprise Index for China

In Europe and Japan there has not yet been a direct hit from the U.S.-China tariff and non-tariff barriers. Even when accounting for a potential tightening of financial conditions, the impact of the U.S.-China tariffs may be negligible on European or Japanese economies and companies.

Japan’s economy and companies may feel relatively little impact from the escalating U.S.-China trade tensions, due to several factors:

  • The renewed trade tensions and risk to global growth may cause policy makers to hold off on the scheduled consumption tax increase for later this year. Japanese stocks would likely welcome a delay since the last time the tax was raised, in 2014, it caused a mini recession and bear market.
  • As noted above, the escalation of US-China tariffs seems to have prompted the Trump administration to push off auto tariffs, a welcome relief for Japanese automakers. 
  • China has accelerated domestic credit growth to offset a slowdown in trade with the United States, which may lend support to demand for Japanese exports to China. 
  • Japan’s widely-watched quarterly survey of business confidence, known as the Tankan, is tracked by a monthly survey by Reuters, and showed that sentiment by large manufacturers rose for the first time in over a year in May. Sentiment has fallen a long way from mid-2018, suggesting businesses have likely already trimmed capital spending and inventories in response to slowdown fears, and could be poised to increase in response to any further improvement.

May saw the first uptick in sentiment by large manufacturers in Japan in over a year

Bank of Japan Tankan Survey

Source: Charles Schwab, Bloomberg data as of 5/22/2019.

The growth outlook for European economies and companies may also be relatively insulated from fallout from the U.S.-China trade salvos, due to a few factors:

  • As with Japan, the resulting push out of potential auto tariffs by the United States is good news for German automakers.
  • European telecommunications equipment leaders could benefit as the United States and China place non-tariff barriers on each other’s domestic giants. 
  • The European Central Bank (ECB) is likely to maintain its stimulus programs, and may further support Eurozone banks with cheap long-term refinancing this summer as an insurance against tighter financial conditions. 
  • The global slowdown may cause some European countries to lean toward more fiscal stimulus. For example, Germany, Europe’s largest economy, has room for tax cuts after running a budget surplus for years, as you can see in the chart below.

German budget surplus

Germany Govt Deficit-Surplus as % of GDP

Source: Charles Schwab, Bloomberg data as of 5/22/2019.

Of course, the U.S. delay on auto tariffs could end up being only temporary and drag Europe and Japan into the fray. These concerns may have resulted in stocks in the MSCI EAFE Index, dominated by stocks from Europe (63% of market capitalization of the EAFE Index) and Japan (24% of market capitalization of the EAFE index), having pulled back a similar amount as U.S. stocks since the trade tensions were renewed, as you can see in the chart below. However, they didn’t fall anywhere near as far as Chinese stocks, measured by the MSCI China Index.

International (EAFE) stock market performance similar to U.S. since escalation of trade tensions

MSCI EAFE vs MSCI China vs SP 500

Source: Charles Schwab, Bloomberg data as of 5/22/2019.  Past performance is no guarantee of future results.

Clearly, markets aren’t too stormy yet (except in China) and U.S. and EAFE equity market performance has been very similar since trade tensions escalated. But the U.S.-China trade tempest may not subside anytime soon and investors may continue to look for shelter from the rising storm. There are reasons unrelated to trade that stocks based in Europe and Japan may suffer. However, staying as far as possible from the successive waves of trade barriers might offer a relative growth advantage for companies based in EAFE countries, and support the forecast by the consensus of Wall Street analysts for slightly stronger earnings growth for companies in the MSCI EAFE index than in either the United States or China in 2019. 

So what?

Trade tensions will likely continue to contribute to increase volatility and the  longer it drags on, the bigger hit to economic growth, consumer/business confidence and the stock market. Our neutral stance around U.S. equities suggests keeping allocations no higher than longer-term strategic targets, with a large cap bias; using volatility for rebalancing opportunities. For those investors who don’t have broad international exposure, now may be a good time to consider areas that may feel less impact from the U.S.-China trade dispute. 

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Important Disclosures

International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market, economic or political conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. This content was created as of the specific date indicated and reflects the author’s views as of that date. Supporting documentation for any claims or statistical information is available upon request.

Diversification and rebalancing of a portfolio cannot assure a profit or protect against a loss in any given market environment. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events may be created that may affect your tax liability

Past performance is no guarantee of future results.  Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.  The policy analysis provided does not constitute and should not be interpreted as an endorsement of any political party.

The S&P 500 Composite Index is a market capitalization-weighted index of 500 of the most widely-held U.S. companies in the industrial, transportation, utility, and financial sectors.

The Chicago Board of Exchange (CBOE) Volatility Index (VIX) is an index which provides a general indication on the expected level of implied volatility in the US market over the next 30 days.

The Institute for Supply Management (ISM) Manufacturing Index is an index based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders and supplier deliveries.

The National Federation of Independent Business (NFIB) Small Business Optimism Survey which is based on the responses of 740 randomly sampled small businesses in NFIB's membership, surveyed monthly

The Industrial Production Index (IPI) is an economic indicator published by the Federal Reserve Board of the United States that measures the real production output of manufacturing, mining, and utilities.

The Empire Manufacturing State Index is a regional, seasonally-adjusted index published by the Federal Reserve Bank of New York distributed to roughly 175 manufacturing executives and asks questions intended to gauge business conditions for New York manufacturers. 

The Philadelphia Federal Index is an index that is published by the Philadelphia Federal Reserve Bank and is constructed from a survey of participants who voluntarily answer questions regarding the direction of change in their overall business activities. The survey is a measure of regional manufacturing growth. 

The Citigroup Economic Surprise Index measures the amount that economic activity surprised or disappointed relative to analyst expectations. It’s defined as weighted historical standard deviations of data surprises (actual releases vs Bloomberg survey median). A positive reading of the Economic Surprise Index suggests that economic releases have on balance beating consensus. The index is calculated daily in a rolling three-month window. 

Bank of Japan Tankan Diffusion Index is short term economic survey of enterprises in Japan. It consists of two parts: a judgement survey and a quantitative survey on quarterly data and annual projections.

The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. The MSCI EAFE Index consists of the following 22 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.

The MSCI China Index captures large and mid cap representation across China H shares, B shares, Red chips and P chips. With 138 constituents, the index covers about 85% of this China equity universe.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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