Markets react to another round of tariffs

Thought of the day

by Chief Investment Office 02 Aug 2019

What happened?
In a series of tweets on 1 August, President Trump announced his intention to impose another round of tariffs on Chinese goods. Barring some sort of agreement, a new 10% tariff will be applied to the remaining USD 300 billion of US imports from China that were not already impacted by the 25% tariffs, taking effect beginning on 1 September.

In his announcement, President Trump accused Beijing of reneging on a series of promises in this year's ongoing trade talks. Those promises included an increase in the purchase of US agricultural goods to help narrow the trade gap between the world's two largest economies, as well as, according to President Trump, a pledge from President Xi to halt the sale of fentanyl in the US.

This represents a re-escalation of US-China trade tensions after the truce that was announced at the G20 summit on 29 June, and comes just as US trade negotiators returned from a trip to China.

Stocks, which had been in the green in early US trading, sold off sharply following the announcement. The S&P 500 closed down 0.9%. In fixed income, 2-year and 10-year US Treasury yields fell by 12bps and 11bps, respectively, and the German 10-year yield dropped to –0.45%, a new record low. In currency markets, the Japanese yen rallied 1.3% to USDJPY 107, the Australian dollar fell 0.6%, and emerging markets saw broad losses. Meanwhile, gold rose 1.2% to USD 1,444/oz and WTI crude oil closed at USD 54/bbl, down 7.9% on the day.

What comes next?
President Trump's announcement does stress the importance of ongoing negotiations, and there is ample time for negotiations to result in another truce, thereby avoiding or delaying these threatened tariffs. However, this re-escalation of tensions also indicates that President Trump is prepared to ramp up trade disputes even while campaigning for reelection. The president even seems willing to up the ante even further, by suggesting that the rate could rise to 25%, or even higher, if negotiations remain stalled.

Most businesses should be able to survive the 10% tariff, but they will have to worry about the possibility of that rate rising again in the future. Furthermore, we now see a higher risk that tariffs could also be placed on auto imports. Back in May, Trump announced that a decision on auto tariffs would be delayed by six months to allow time for negotiations, and it appears that little progress has been made since then.

The uncertainty created by the trade disputes has been weighing on business investment spending, which turned negative during the second quarter. Today's announcement will only serve to create additional downward pressure on business confidence. It will be important to monitor business sentiment surveys to see whether there is a significant impact on the demand for workers—if businesses stop hiring, this would greatly increase the risk of a recession. The global manufacturing sector has already been under pressure from the trade disputes, and these additional tariffs could make things even worse. This morning, the US ISM Manufacturing PMI fell to 51.2—the lowest since August 2016—with many respondents mentioning tariffs as a negative for their business. The index could easily dip below 50 into contraction territory next month, though this doesn't imply a broad economic recession.

The aggressive change in tone by major central banks, and the hope of a deal to forestall implementation before 1 September, may help to take some of the sting from this announcement. However, if implemented, these proposed tariffs would levy 10% on USD 300 billion of Chinese imports, translating into an approximately USD 30 billion tax on US consumers, or 0.15% of US GDP. The cumulative economic impact—including second- and third-order effects, as well as any Chinese retaliation—could be much larger. We also estimate that, if implemented, these tariffs could place an additional 1% drag on S&P 500 earnings growth over the next 12 months.

It's important to keep in mind that for the previous rounds of tariffs on China, the Office of the US Trade Representative specifically chose goods that could be imported from somewhere else or be produced domestically. This dampened the impact of those tariffs somewhat on the US consumer, but substitutability is less straightforward for the goods affected by the new tariff. So while the tariff rate on these goods is lower, it may have a similar impact, because there is little production capacity either domestically or in other countries to substitute for imports from China.

What does this mean for investors?
While we ultimately believe that US-China trade tensions will be resolved through negotiations, equities may struggle to move markedly higher until there is greater certainty. Stock valuations are not cheap by historical standards, but even with tariffs' drag on S&P 500 earnings, we continue to expect solid EPS growth over the next 12 months. In addition, while global economic growth is softening, accommodative central banks are helping to mitigate recessionary risks.

We continue to recommend a selective overweight to equities, but we balance these positions with countercyclical trades to protect against downside risks. In addition, we recommend that investors consider "carry trades" that can help boost portfolio income and provide current return in a sideways market environment.

  1. In our FX strategy, we overweight a basket of higher-yielding emerging market currencies (Indonesian rupiah, Indian rupee, South African rand) against a basket of lower-yielding currencies (Australian, New Zealand, and Taiwan dollars). We think these currencies should benefit from a favorable carry environment, as well as steady global and emerging market economic activity.
  2. Markets are underpricing inflation, in our view, especially with the Fed committed to achieving that part of its dual mandate, so we recommend an overweight to Treasury Inflation-Protected Securities (TIPS) versus US government bonds.
  3. We see good long-term value in emerging market sovereign bonds. US dollar-denominated emerging market sovereign bonds have a favorable longer-term risk-return outlook, in our view, with spreads of around 330bps over US Treasuries. This is particularly attractive at a time of low rates.
  4. We continue to recommend an overweight to US, Japanese, and emerging market stocks which should continue to fare well in an environment where central banks are committed to supporting growth. To manage the risk of equity drawdowns if growth disappoints or if trade negotiations fail to reach a timely resolution, we continue to recommend an overweight to long-duration Treasuries and an underweight to international developed market stocks (especially Eurozone stocks). We also recommend a variety of investment themes with the potential to offer attractive yield. For example, short-term corporate bonds offer attractive current yield without taking on excessive credit or interest-rate risk, and master limited partnership (MLP) bonds offer attractive coupon income relative to other investment grade sectors.
  5. Chinese stocks remain one of our preferred emerging markets, though a bumpier ride toward an ultimate US-China deal could complicate the short-term outlook. Within emerging market equities, we also favor Brazil and Malaysia.For more information on how to manage an uncertain short-term environment while continuing to invest for long-term goals, please see our Plan. Protect. Grow. report.

Should you have any comments or questions, please email ubs-ciowm@ ubs.com.

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