MIKE TOWNSEND: Congress may be in recess this week, but with the impeachment inquiry launched and a high-stakes U.S.-China trade meeting on tap, it’s anything but slow in Washington.
Welcome, everyone, to WashingtonWise Investor, an original podcast from Charles Schwab. I’m your host, Mike Townsend. We’ve got a lot to talk about this week. In just a few minutes, I’ll speak with Jeff Kleintop, Schwab’s chief global investment strategist, about developments around the world and implications for investors.
But first, let’s begin with our usual look at the top stories—and right now there is no bigger story than the “I” word—impeachment. The decision by the House Democratic leadership to launch a formal impeachment inquiry has dramatically altered the political landscape, and it’s all anyone in Washington is talking about. I’ve already been asked a number of questions about whether the impeachment process will impact investors, so let me share three quick thoughts.
First, don’t expect any big market reaction. Markets understand that even if the president is impeached in the House, it’s unlikely—barring some new revelation that comes out during the inquiry—that the Senate will be able to muster a 67-vote supermajority to convict the president in a trial and remove him from office.
A similar situation unfolded two decades ago when the markets were pretty sanguine about the impeachment proceedings against then-President Bill Clinton. In fact, from October 1998, when Clinton was impeached, to February 1999, when he was acquitted by the Senate, the S&P 500® rose by more than 28%. At the time, the market was much more interested in the tech boom that was going on than it was in impeachment proceedings—and I think the same is true this time. The market is much more concerned about issues like trade and the economy than it is about the impeachment process.
Second, the markets will be watching what impact the process has on the rest of the Congressional agenda. There are a number of legislative priorities that are poised for action this fall, including a vote on the U.S.-Mexico-Canada trade agreement, health care bills to curtail so-called “surprise billing” and address skyrocketing prescription drug prices, and a retirement bill with some positive changes that should enhance opportunities to save. All of these have some bipartisan momentum that could be stopped in its tracks if the impeachment process becomes bitterly partisan and divisive.
Third, the impeachment question will throw a wrench into the 2020 campaign. There’s little question it will be a major distraction for the president as he heads into his re-election year. On the Democratic side, it may become more difficult for candidates to keep the focus on their policy ideas amidst the distraction of constant questions about impeachment. And remember that, of the 19 candidates still in the running, there are seven senators and two members of Congress who could be directly involved in the process, taking time and energy away from their campaigns.
While the process doesn’t necessarily have a direct market implication, it does add another element of uncertainty into an already chaotic time for the markets.
The other important news for investors to follow is this week’s meeting between the top negotiators from the U.S. and China. Chinese Vice Premier Liu He will lead a delegation to Washington later this week for the first face-to-face talks since the beginning of August. The fact that China is sending its top trade official to the United States is significant, showing that China is serious about making this, the 13th round of talks, productive.
Here in Washington, there is renewed optimism that progress can be made. In fact, the U.S. administration has been hinting in recent weeks that some kind of interim agreement could be reached that would show progress toward a larger trade deal—and there’s no question that this administration could use some good news right now. Investors should keep an eye on these talks—but be wary: We saw momentum multiple times earlier this year, only to have the talks fall apart.
Let’s turn now to the Why It Matters segment, where I look at a story that listeners may have missed and offer some perspective on why it is important. This week, my focus is on Fannie Mae and Freddie Mac, the mortgage giants that buy about half of U.S. mortgages.
Since the financial crisis in 2008, the two companies have been in government conservatorship, operating with significant restrictions, including the requirement that they turn over any profits to the Treasury beyond a $3 billion maximum in capital. That was designed to reimburse the Treasury for the $187 billion taxpayer bailout they received in 2008. Both companies have long since paid back what they owed, but Congress has been unable to come to an agreement about how to transition the companies out of conservatorship over the past decade.
Last week, the Treasury Department and the Federal Housing Finance Authority announced that Fannie Mae would be able to retain up to $25 billion in earnings, while Freddie Mac will be allowed to retain as much as $20 billion—the first major step in the administration’s housing reform efforts. This move accelerates the two companies’ ability to raise the $100 billion or more in capital needed to guard against potential losses and transition back to the private sector. Look for additional steps in the coming months—but realize that the administration cannot simply turn Fannie and Freddie back into private entities without the involvement of Congress. And Congress remains very divided on exactly what to do about the two mortgage giants. Bottom line—expect a kind of muddled, hybrid status for the next year or more, with the administration loosening some of the restrictions that have been in place since the financial crisis but retaining considerable oversight.
For today’s deeper dive, we’re going to look at some of the international issues that are giving investors anxiety. And there’s no better person to do that with than Jeffrey Kleintop, chief global investment strategist here at Schwab. Thanks for joining me for a quick spin around the globe, Jeff.
JEFF KLEINTOP: Hey, Mike, Thanks for having me on WashingtonWise.
MIKE: Let’s begin with China—and, in particular, I want to talk about tariffs. I think there is a lot of confusion in the media about exactly what tariffs are, how they work, and who ends up paying for them. The U.S. has imposed all kinds of tariffs that we don’t even notice, including on countries with which we have great trade relationships. So how do tariffs work?
JEFF: Well, it’s pretty simple. Tariffs are collected by customs agents at ports of entry and they’re added to the purchase price paid by the buyer when they collect the goods—it’s a lot like a sales tax. And they act the same way; they make the products more costly.
Now, I should point out that not all tariffs are equal in their impact. Now the U.S. is about to impose nearly $8 billion in tariffs on the European Union—but it’s not a big deal and didn’t really attract much news. And that’s because it’s over a long-running dispute over European subsidies for Airbus, the European airplane maker. And it’s playing out with the approval of the World Trade Organization.
The WTO has found that EU subsidies violate international trade rules and determined the amount of tariffs the U.S. can impose. And that means the U.S. will impose limited tariffs now that the WTO authorized them—not a large general tariff based on a White House–imposed deadline. And that limits the impact across industries and the economy and the markets.
MIKE: Well, let’s try to bring the impact of the China tariffs closer to home.
As you’re probably aware, National Public Radio has been doing an interesting analysis over the past few months, where they have been monitoring prices on about 80 products at a Walmart in Georgia to see what the impact of tariffs is on the consumer. What they have found is that some products have seen significant price increases, some have seen almost no increases, and some have actually seen prices fall. It really depends on the product. So are there specific winners and losers in this trade war? And from an investing perspective, are there any types of companies or sectors that have been big winners?
JEFF: In terms of winners and losers, there was an idea among investors early on that larger companies would lose due to their greater overseas sales exposure that may be more impacted by the retaliatory tariffs in contrast to more domestically oriented smaller-sized businesses. But over the past year, we’ve actually seen that it’s often been the smaller U.S. businesses—those that are more dependent upon lower-cost imports for their products—that have suffered more.
There aren’t clear sector winners and losers, but there may be countries that fit that description. Overall U.S. imports are basically unchanged from the end of last year. They haven’t really gone up or down very much, but U.S. imports from China have plunged. China’s loss seems to have been a gain for other emerging markets not subject to the U.S. tariffs.
According to the U.S. trade data, the rise in U.S. imports from five emerging market countries, Vietnam, South Korea, Taiwan, Mexico, and India—all of which have seen large increases, most of them double-digit percentage increases, in their exports to the U.S.—have offset the falloff from China.
So is China losing out to other emerging markets? Maybe, but those businesses in China can focus on European customers that may be switching their suppliers to China from Vietnam. So it could be a wash as the tariffs simply shift supply chains. And the stock market suggests that’s the case. We’ve actually seen China’s stock market outperform most other Asian emerging markets this year, with some pretty strong gains.
Which is an important reminder that tariffs aren’t everything. Markets seem to react daily to tariff news, but not so much on a slightly longer-term basis. For example, stocks in the U.S. and China haven’t done poorly this year despite the escalating trade tensions and all the attention they’ve received. And that’s important to keep in mind.
MIKE: Well, you’re talking about how the impact on Chinese stocks has been mild.
One thing that can be hard for investors to get a handle on is how much the trade war is really impacting China’s economy—and whether there is a point at which that economic impact becomes significant enough to pressure China into concessions at the negotiating table. How much impact do you think this is having on China?
JEFF: Overall U.S. imports from China are equivalent to about 8% of U.S. retail sales. Now, that might sound low given all the stuff we buy that says “Made in China.” But let’s break this down—if a pair of sneakers that have a “Made in China” label cost $80 in the U.S., well, not all of that price goes to the Chinese manufacturer. In fact, the bulk of the retail price pays for transportation of the sneaker in the U.S., rent for the store where they are sold, the cost of marketing the sneakers, and the profit margin for the U.S. retailer.
So much of the price that U.S. consumers pay for imported goods actually go to U.S. companies and workers. So I’m talking about just the wholesale price for the product itself—what the Chinese producer gets—and that’s equal to about 8% of U.S. retail sales.
Retail sales in the U.S. and China are about equal in dollar terms—so they are equivalent to about 8% of China’s retail sales. So it would only take an 8% increase in retail sales in China to replace everything China sells to the U.S. And guess what, as of the latest August data, China’s retail sales have grown 8% from a year ago. Now, that may underestimate the impact on some industries, suggesting the whole thing is a wash. But you get the idea. The notion that China is totally dependent upon sales to U.S. consumers, and that their economy would crash without those sales, is more than a little out of date. The U.S. is important, but far from the most important driver of China’s economy.
MIKE: Well, Jeff, that’s great insight. I think we may be over-estimating how much China is suffering in this trade war. But I’ve heard it said that there are no winners in a trade war. Why is that?
JEFF: Because, generally speaking, I think everyone’s better off with trade. We come to work and trade our skills for a paycheck—and that’s better than each of us trying to build our own houses, or grow our own food, and invent our own medicines. So when two parties come together and find a mutual benefit from an exchange, both parties are better off.
Limiting competition only to domestic suppliers is generally bad for consumers. It tends to limit choice. It can increase prices, and result in less innovation.
But focusing on it just from an investment perspective, U.S.-based companies want to sell to emerging-market Asia because that’s increasingly where the customers are. The middle class in China now has more spending power than the U.S. middle class.
And it is growing much more rapidly. For example, you know the biggest sales day in the world always takes place in November—but it’s no longer Black Friday. For several years now it’s Singles Day, which falls on November 11—this is the holiday Alibaba in China created about 10 years ago. Their sales in China are seven times what they are on Black Friday in the U.S. And there are many U.S. companies that do a high volume of sales on Singles Day in China.
Remember, the population growth in the U.S. is nearly flat and incomes are not rising rapidly. Being cut off from the rapidly growing markets of Asia would negatively impact the outlook for those companies.
MIKE: Well, Jeff, while the U.S.-China relationship has dominated the headlines, there are actually a number of other important trade agreements that have been making significant progress. The U.S. and Japan signed a deal, a U.S.-India agreement is in the works, and then there is the U.S.-Mexico-Canada agreement that may get a vote in Congress this fall. From an investor’s perspective, how important are these various other deals?
JEFF: Mike, I think they are important for three reasons. First is their size. These are big deals. Japan is the third largest economy in the world, behind China, and a major trading partner of the U.S. Canada and Mexico are two of our biggest trading partners. So it affects a lot of goods we buy. And these aren’t, you know, these aren’t minor deals. U.S trade with Canada and Mexico are each about the size of trade with China, so they’re big.
Second, they have no increase in auto tariffs. And the disruption that auto tariffs could have on supply chains that crisscross so many borders could be very costly across a lot of industries, so not having that included is important.
And third, it proves trade deals can be done in this environment. It’s supported an environment of investor optimism that a deal with China can actually get done.
MIKE: Well, let’s hope that can carry over to the China talks.
Let’s shift gears to the Middle East, particularly the precarious relationship with Iran. After the air strike last month on Saudi Arabian oil facilities, things seemed to deteriorate even further. How concerned should investors be about a possible military confrontation with Iran, and what would the market impact be?
JEFF: Geopolitical conflict is an ever-present risk for investors. While the events are often unpredictable, and the countries involved vary, the markets' reactions have actually often been predictable.
Although it might pose another threat to an already-vulnerable global economy, markets’ past negative responses to U.S. military strikes have tended to be pretty short in duration. Now, unfortunately, we’ve got a long history of U.S. missile strikes outside of declared war in the past 30 years to look at that we can use to assess the potential market impact of these types of geopolitical events.
Now, the global stock market reaction has been mixed—roughly half of the time the day after the event, the stock market saw losses. But the other half, the markets were flat, or even showed gains—that’s not a pattern we can take much stock in.
Now, Mike, when grim headlines are in the news, I think investors are best served by remembering that geopolitical risks are a regular part of investing, and that a long history of geopolitical developments shows us that holding a well-diversified portfolio may buffer the short-term market moves that are most often the result.
MIKE: Well, there’s no question that in these times, when it seems like big news happens every day, a military confrontation with Iran would probably be among the biggest.
Another world hot spot, not in a military sense, but maybe just as unpredictable, is Brexit.
I’m guessing the Brexit situation remains as perplexing and unpredictable to you as it does to most of the rest of the world. So what are your thoughts on the various scenarios that are in place for Britain to leave the European Union?
JEFF: For the moment, it appears a damaging “no deal” Brexit may be avoided should Parliament succeed in taking back control of Brexit from the Prime Minister—which seems to be taking place.
However, there are still a number of potential outcomes. In our view, the main options, in order of their likelihood, are, first, a further delay to the end of January.
Second would be passing former Prime Minister May’s Brexit deal in late October—the one that has already been voted down three times, they run that again.
And then, there’s always the possibility of exiting without a deal on October 31st, the current deadline for Brexit. And then further out on the likelihood spectrum is maybe crafting a new deal, or even revoking Brexit entirely.
So while a delay or deal seems most likely, it’s important to recognize that Brexit isn’t resolved if a deal is passed. It’s not a done deal, simply because the deal isn’t a comprehensive outline for Brexit. There is no provision in former Prime Minister May’s deal for a post-“customs arrangement” trading relationship between the U.K. and the EU.
So they still have to figure that out. Also, the U.K. would still be constrained from entering free trade agreements with non-EU countries like the U.S. So a whole other series of potentially contentious negotiations would then need to begin.
MIKE: I think there’s little question that no matter how Brexit plays out, it’s likely to have a significant effect on the British economy? But what’s the potential market impact in the U.S. and for global markets generally?
JEFF: While these longer-term trade agreements are negotiated, there will be little immediate economic impact on the U.K. or the rest of the world. The U.K. will remain in a customs arrangement with the EU all the way until the December of 2020—which then could be extended even further, or until a better solution is found to keep the Irish border open.
As a result, there’ll be no need for tariffs, quotas, or land border checks between the U.K. and the EU. And, importantly, most U.K. financial services companies will be able to access the EU market, as long as the U.K. maintains similar regulations to the EU.
So while markets may not be able to breathe a total sigh of relief that business wouldn’t be disrupted in the event a deal is passed, much of the near-term uncertainty would be resolved and likely to sustain the rebound in the British pound and U.K. stock market from near the lows seen since the July 2016 Brexit referendum.
But on the other hand, a “no deal” Brexit would likely push the U.K. into a recession, with GDP dropping sharply by early 2020. The Bank of England’s latest updated analysis of the economic impact of a no-deal Brexit includes an initial plunge of 5½% of GDP.
It would also double the unemployment rate to 7%, and a big jump in inflation rate to over 5% from around 2% now, as the pound falls and import prices rise. That loss of jobs and erosion of spending power from the rise in inflation may crush consumer spending, which makes up two-thirds of the U.K. economy. With U.K. stocks up around 10% this year, there is substantial downside risk in the form of a bear market in the event of a severe recession and business disruptions. The hit to confidence and the outlook to earnings could be pretty severe.
However, a “no deal” Brexit may be far less impactful on the rest of the world, at least looking at relative exports. EU exports to the U.K. make up about 3-4% of GDP for the remaining EU countries. Looking outside the EU, the U.K. is one of the top five trading partners of the U.S., but this relationship makes up less than 1% of U.S. GDP. And Japan has a similar-sized exposure to the U.K. on a percentage of GDP basis. So not a big deal there either.
So while the direct impacts may be generally minor outside the U.K., and there’s been more than three years for businesses to prepare for the possibility, the impact of a “no deal” Brexit—including a recession in the sixth-largest economy in the world—would act as an additional drag in a global economic environment already growing at a below average pace and vulnerable to shocks.
MIKE: Well, thanks Jeff, terrific information as always. That’s Jeff Kleintop, Schwab’s chief global investment strategist. You can follow Jeff on Twitter @JeffreyKleintop, and you can find there his 90-second video each week—on what he’s watching in the week ahead. I highly recommend it.
In this episode’s Election 2020 update, I want to address something that I have been getting a lot of questions about recently, and that is tax proposals from various candidates for the Democratic presidential nomination. There are a number of proposals that could affect investors—proposals for a wealth tax, or a financial transaction tax, or proposals that include the taxation of certain unrealized gains.
In a crowded primary field, candidates need to distinguish themselves from one another, and in this campaign environment, one way to do that is by throwing out a variety of proposals that would increase taxes on wealthier filers. At this point, however, remember just how far away these plans are from becoming reality.
Democrats would need to win the White House next November, win control of the Senate, and retain their majority in the House—those things, particularly winning the majority in the Senate, are far from assured 13 months before the election. But another important factor to remember is that Democrats are not united on these proposals. Even if Democrats have the necessary majorities in 2021 to turn these ideas into legislative proposals—there’s no guarantee they would be able to come together on the details.
In an upcoming episode I’ll devote time to a deeper discussion of some of the specific proposals being put forward by the candidates and their potential impact on investors. For now, though, don’t get too distracted by these proposals, as a lot can and will happen in the next year and a half before we know whether they even have a realistic chance of becoming law.
I’ll be back on October 22nd with another episode of WashingtonWise Investor. Demetra Sullivan, a vice president here at Schwab who oversees our retail branches in the west, will join me to consider the retirement savings bill that is pending in Congress. We’ll walk through some of the important changes for investors that would come about if that bill becomes law.
Until then, thanks for listening. Please consider leaving us a review or a rating on Apple Podcasts or your favorite listening app, and make sure you subscribe so you don’t miss an episode. For important disclosures, see the show notes or Schwab.com/Washingtonwise, where you’ll also find the transcripts of every episode.
I’m Mike Townsend, and this has been WashingtonWise Investor. See you next time—and keep investing wisely.