Global trade tensions have been elevated since early 2018. Much of the focus has centered on a tit-for-tat exchange of retaliatory tariffs between the U.S. and China, but trade restrictions with North American and European allies are also a factor.

The trade tension between China and the U.S. is bigger than just trade, which makes it more difficult to reach a quick deal. When we look at policy moves from China in the last decade, one thing becomes clear: China wants a seat at the table with the U.S. in world affairs. Naturally, the U.S. wants to keep its leadership role.

The escalated tension created both investor and business uncertainty and increased the potential for a mistake. The tariffs haven’t had a significant impact on economic indicators. Ultimately, we believe it is in the best interest of both parties that a long-term agreement will be reached. Investors should expect markets to rise and fall in the meantime in response to trade-related pronouncements from Washington and Beijing.

How we got here

As China’s influence around the world has increased, U.S. concerns about China have grown. Some have accused China of not playing by the rules.  President Trump argued that China is violating intellectual property rights by forcing foreign companies to engage in joint ventures with Chinese companies to give the Chinese companies access and permission to use, improve, copy and steal their technologies.

In 2018 the U.S. imposed tariffs on $250 billion worth of Chinese goods and China retaliated with tariffs on $110 billion worth of U.S. goods. Just recently, talks broke down and the U.S. increased tariffs from 10% to 25% on $200 billion worth of Chinese imports. China retaliated by raising the tariffs by 15% on $60 billion of U.S. goods (see chart at right)[1].

The U.S. is also concerned that Chinese telecom company Huawei Technologies could pose a security risk and may be used as a backdoor for spying by the Chinese government. Trump added Huawei to a trade blacklist, which prevents the company from buying parts and components from American companies without U.S. government approval

Market Effect

Tariffs are a tax on imported goods and are paid directly by U.S. importers of Chinese goods. The tariffs are paid to the U.S. Customs & Border Protection Service at the U.S. border. They are not paid by the Chinese to the U.S. Most economists argue that tariffs reduce economic activity by raising prices for consumers. However, the tariffs thus far have not been large enough to have a significant effect on economic growth. They also haven’t been large enough to move inflation higher.

The tariffs in place so far represent only about .3% of U.S. GDP. Even if all the threatened tariffs were to be imposed, it would still only represent about 1.2% to U.S. GDP (see chart).

The tariffs have affected world volumes however. We’ve seen a meaningful decrease over the last year[2] but still not significant enough to have us worried.

A long-term tariff increase could hurt American businesses with significant parts of their supply chains, consumer bases and other business dealings in China.

We’ve seen some signs of this already. During Q1 2019, S&P 500 companies with over half their sales coming domestically enjoyed earnings growth, on average, of 6.2%. Meanwhile, those companies with over half their sales coming from international sources saw their earnings decline by 12.8%[3]. We believe businesses will eventually adjust but in the short-term earnings could be further hurt. So far U.S. stock prices have been volatile but resilient. As of May 23^rd, 2019, the S&P 500 TR Index is about 5% off its all-time high reached earlier in May.

The impact on non-U.S. stock prices been more significant. The Chinese stock market has underperformed the S&P 500 TR Index since the tariffs were announced last year[4].

In March 2009, China represented 12% of the MSCI Emerging Markets Index. Fast forward 10 years, and that has increased to 33%. China’s underperformance has had a significant impact on the MSCI Emerging Market Index[5].

While the ongoing trade tension has hurt emerging market stocks, we believe much of the risk has already been priced in. You can see that in the valuation difference between U.S. and non-U.S. stocks[6]. In our judgement, this could be an opportunity to buy Emerging Market stocks at lower valuations.

Summary

It has been a protracted and complex negotiation with China. There are certainly risks that things could get worse, but ultimately, we believe a resolution is likely. The impact so far has been felt mostly in emerging market equity prices and less so in U.S. stock prices and U.S. economic data. Continued market volatility seems likely until there’s some sort of resolution. The U.S. and China are tied at the hip when it comes to international trade and it’s in everyone’s best interests to resolve this dispute.

IMPORTANT DISCLOSURES

Leonard Rickey Investment Advisors, PLLC (“LRIA”), is an SEC registered investment adviser located in the State of Washington. Registration does not imply a certain level of skill or training. For information pertaining to the registration status of LRIA, please contact LRIA or refer to the Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov).

This newsletter is provided for general information only and contains information that is not suitable for everyone. As such, nothing herein should be construed as the provision of specific investment advice or recommendations for any individual.  To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced herein is historical in nature and is not an indication of or a guarantee of future results. All indices are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment.

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INDEX DEFINITIONS

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. It cannot be invested into directly.

The MSCI Emerging Markets Index is a float-adjusted market capitalization index that consists of indices of approximately 800 stocks and is designed to measure equity market performance in 23 emerging economies: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, , Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey, and the United Arab Emirates.

China A-shares represented by the MSCI China A Onshore Index, a benchmark of Chinese equities largely traded by Chinese retail investors.

[1] Charles Schwab

[2] Bloomberg, Charles Schwab

[3] FactSet

[4] Capital Group

[5] Data from Morningstar

[6] Source: StarCapital. The presented valuation ratios are market-capitalization-weighted. “Weight” provides the actual country weight. PE (Price-Earnings-Ratio), PC (Price-Cashflow-Ratio), PS (Price-Sales-Ratio) and DY (Dividend-Yield) are based on trailing 12 month values. PB (Price-Book-Ratio) is based on the most recent company financial statements.