The “Trade Wars” saga continues to screen at full theatres around the globe. How much is theatre, for domestic political consumption, and how much is real? That is the key question for investors.
Unfortunately, it looks as if US-China trade relations are going to remain troubled for some time. The macroeconomic impact of the first US$50 billion of import tariffs is expected to be small. Some adverse consequences are already becoming visible. In the case of a few commodities such as soybeans or steel, the price impacts have been large.
For many intermediate inputs it will take more time for higher tariffs to work their way up the production chain and become visible in higher consumer and capital goods prices. The earlier US tariffs on steel and aluminum imports are already pushing up input costs.
Intermediate demand inflation for steel mill products rose to 12.2 percent in July, while the PPI inflation rate for overall core goods intermediate items rose to a near seven-year high of 5.3 percent, according to a report from Capital Economics.
Note that estimates of US-China tariff costs in the media often refer only to the direct or initial impact. They make no allowance for trade diversion or tariff evasion, e.g., when US farmers export soybeans to Brazil which re-exports them to China, adding 10 percent to shipping costs but avoiding China’s 25 percent import tariff.
A key point is that the second round impact of import tariffs is greater than the initial impact in each scenario. Economists dislike trade barriers because they invariably worsen the output/ inflation mix – real output falls and prices are increased whenever trade tariffs are imposed.
This means the macroeconomic costs of US tariffs on Chinese imports will not be felt until well after the November mid-term elections. The IMF thinks the longer-term damage from disruptions to global supply chains will become much more apparent by 2020. If there is no trade deal between the US and China, tariffs could have a strong bearing on the next US presidential election.
It is now 10 years since the last global recession. And in the US, the S&P 500 has enjoyed the second longest rally since 1945 (March 2009 to July 2018, 112 months, versus July 1990 to March 2001, 128 months). But can the rally continue for much longer? Is it now so late in the cycle that the majority of equity returns are likely behind us, with little left for investors to look forward to?
In what follows we look at the returns that investors have typically experienced in the later stages of the business cycle. The late cycle is usually accompanied by rising pressure on global interest rates. This is an issue of great concern to investors in 2018, as the Fed seems determined to proceed with more rate hikes in 2019 and 2020 than the market believes will occur.
One may think of the stocks most negatively correlated to Treasury yields as “bond proxies” and those most positively correlated as “bond hedges”. The late cycle phase is when Quality stocks often exhibit a negative correlation with yields – bond proxies tend to underperform. The more cyclically-sensitive Value stocks, on the other hand, have consistently shown a positive correlation with yields in the mature stages of the business cycle.
How concerned investors should be will also depend on where exactly we are in the mature stage of the cycle. We believe there is still time left for investors to make money from equities in this cycle. Looking at the five instances of yield curve inversions since 1978, the S&P 500 did not peak until eight months later on average, while recession did not begin until 17 months later, on average.
One important caveat is that the peak response is clearly bipolar, so that although the average is eight months, on three occasions it was coincident (zero to two months) and on two occasions it has been much longer (18 to 20 months).
Nevertheless, most recession gauges are not even flashing amber. So despite the increased media talk of the next recession, we think it is too early to worry about the end of this cycle. With the important caveat, however, that there is no external shock such as an oil price spike. That’s a risk that has been increased by the US decision to renew sanctions against Iran at a time when the oil market has only a slim margin of spare capacity.
Lastly, while history reveals it is possible to experience an “earnings recession” without an economic recession, there has never been an economic recession when earnings were still growing strongly. S&P earnings were broadly flat in 2014, 2015 and 2016. That did not prevent the bull market in stocks from continuing, thanks to the acceleration in global quantitative easing during this period.
Even if US rate hikes rule out multiple expansion, double-digit earnings growth in 2019 may still leave enough room for decent equity returns. Provided, of course, that enough progress can be made in negotiations between the US and its major trading partners to avoid a global trade war, which is still our base case scenario.
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