1 Big Thing: Escalating trade war
In today’s daily post, I want to put the US – China trade war front and center and ask whether it matters to growth.
The news, of course, is that US President Trump slapped tariffs on $200 billion worth of Chinese products yesterday. And, unlike in earlier rounds of the trade war, the tariff list targets consumer goods like luggage and furniture as well as industrial goods.
In the statement announcing the tariffs, Trump also warned that were China to take retaliatory action against American farmers or American industries, the US would “immediately pursue phase three, which is tariffs on approximately $267 billion of additional imports.”
On Twitter Trump said:
China has openly stated that they are actively trying to impact and change our election by attacking our farmers, ranchers and industrial workers because of their loyalty to me. What China does not understand is that these people are great patriots and fully understand that…..
— Donald J. Trump (@realDonaldTrump) September 18, 2018
…..China has been taking advantage of the United States on Trade for many years. They also know that I am the one that knows how to stop it. There will be great and fast economic retaliation against China if our farmers, ranchers and/or industrial workers are targeted!
— Donald J. Trump (@realDonaldTrump) September 18, 2018
The Chinese have, indeed, responded by imposing tariffs on $60 billion of American goods. Moreover, the Chinese are targeting specific industries like liquefied natural gas which are crucial to states that Trump carried in the 2016 election. So we should expect tariffs on another $267 billion of Chinese goods in short order.
Who wins this war?
Now, Trump has said the US could win the trade war. And there are three ways he means the US could win. First, the US forces the Chinese to capitulate and agree to the demands of the Trump Administration. Second, the US and China have a war, but only China is hurt economically by that war. Third, the US and China have a trade war, but the US is hurt less than China.
Most economists are telling us the likely best case outcome is the third where everyone ‘loses’ but the US loses less. And I guess you could call that winning in a twisted sense. But I suspect that’s not where Trump is on this. Likely he expects capitulation or great harm to China above and beyond what the US gets. And more pain for China is the likely outcome. But the pain in the US will be unevenly distributed, which is why he has warned of more sanctions if the Chinese target specific industries.
It goes without saying that a tariff is a tax on foreign goods that the government collects but that the foreign producers pass on to domestic consumers in the form of higher prices. Those higher prices apply not only to the foreign goods though. They also bid up prices by competitors, causing domestic consumers to pay higher prices all around.
Right now, consumer prices are moderating after shooting up 2.9% in the year to July 2018. The last consumer price inflation number released on Thursday showed inflation up 2.7% in the year to August. Excluding volatile items like food and energy, the number falls to 2.2%.
I think the these numbers will attract the Fed’s attention given how low the headline unemployment figure is. And so, at the margin, any imported inflation due to tariffs, will accelerate the pace of rate hikes we see in 2019. In a worst case scenario, the combination of inflation, rate hikes and slowing growth could mark a tipping point for the US. But on the whole, I don’t see the tariffs as a big inhibitor economically.
2 – Economic confidence is faltering
My concern is more on the existing economic trajectory. Merrill Lynch’s Global Fund Manager Survey revealed some very worrying statistics regarding thinking about where the global economy is headed. When asked how they think the economy will develop in the next 12 months, fund managers, the percentage expecting a stronger economy was its lowest in nearly seven years.
This goes hand in hand with the increase of people talking about a potential recession or financial crisis by the end of 2020.
3 – Capex is underperforming buybacks
And it’s not just fund managers and market analysts showing greater pessimism. If you look at companies’ resource allocation, it paints a worsening picture as well. Here’s how Bloomberg puts it:
The biggest use of cash among S&P 500 companies is making their public footprints smaller — a strategy that’s paid dividends in 2018.
According to Goldman Sachs, aggregate share repurchases (or buybacks) rose by nearly 50 percent to $384 billion in the first half of 2018. That tops the $341 billion spent on capital expenditures, which are rising at the fastest pace in at least a quarter century.
“For the first time in 10 years, buybacks are garnering the largest share of cash spending by S&P 500 firms,” writes chief U.S. equity strategist David Kostin. “Capital spending has typically represented the largest single use of cash by corporations, a position it has held for 19 of the past 20 years.”
According to Goldman, buybacks are up 48% in 2018, whereas capital expenditure is up only 19%.
And the buyback stocks are doing the best in the market as a result. Bloomberg shows that a basket of stocks with the highest buyback yield beats the S&P 500, which in turn beats companies that spend the most on capex and R&D relative to their market capitalization.
Final thoughts
None of this has to be fatal to the US business cycle, of course. But the investor confidence, buybacks and capital expenditures are hallmarks of late cycle behavior. There are other hallmarks as well. Right now, the FANG stocks are down an average of 15% from 52-week highs. And US 10-year yields are back above 3%.
For now, the US economy looks as bright as any major economy in the world. A bitter trade dispute with China is not a game changer. But, in the context of end of cycle markers, it only adds to potential downside risk.