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Looking Backward and Forward The 2nd quarter of 2018 was eventful. The US unemployment rate, inflation, and the Fed remain hot topics for the market. In addition, the Trump administration continues to play an active role stirring up the market, with its decision to exit the Iran nuclear deal, its historic meeting with North Korea leader Kim Jung Un, and a brewing trade war with a wide range of nations.
The Economy and the Fed: On June 13, the US Fed raised interest rates for the second time this year and upgraded their interest forecast from three to four total increases in 2018, as unemployment falls and inflation overshoots their target faster than previously projected. The US unemployment rate fell to 3.8% in May, and the Fed now projects the rate to fall further to 3.6% in Q4 and 3.5% in 2019 and 2020. On inflation, the Fed officials forecast a slight overshoot of their 2% target starting in 2018 at 2.1%, and running through 2019 and 2020, compared with a 2020 overshoot in March’s projections. The median estimate for 2018’s economic growth is 2.8%, up from 2.7% in March, with projections unchanged for 2.4% in 2019 and 2% in 2020. Overall, the US economy is in good shape, and the Fed’s updated decision of four rate moves in 2018 is largely in line with consensus after Q1 US GDP and inflation data. The US equity market has taken the new rate hike well, with limited volatility. The 10 Year US Treasury bill yield peaked in mid May at 3.1%, and has retreated to below 3% as investors expect the good economy to continue without overheating.
Exiting the Iran Deal: On May 8, the Trump administration announced its withdrawal from the 2015 Iran nuclear accord, which sent oil prices to the highest levels since 2014. Most market participants expect that the Iranian oil production and exports will decline as the US reinstates severe sanctions against the country. In late May and early June, oil prices, however, retreated due to expectations that OPEC would announce production increases after its meeting in Vienna in late June. On June 22, OPEC said it would increase output by 600,000 bpd (barrels per day) starting in July, much less than what the market expected, which sent oil prices higher again. Despite the recent up tick of oil prices, expectations for 2019 and 2020 are that the price of oil per barrel will likely retreat to low $60s or high $50s, as shale and other unconventional production in the US, Canada, and Brazil will respond to the currently attractive oil prices, and overwhelm the market with big supplies.
Summit with North Korea: So it happened. President Trump and North Korean leader Kim Jong Un met in Singapore and are committed to establishing “new US-DPRK relations”. The US promises to provide unspecified “security guarantees” to North Korea, and Kim reaffirmed his “unwavering” commitment to complete denuclearization. The written agreement released by the two governments contains no details on how to make the denuclearization process complete, verifiable and irreversible. However, Trump said North Korea would begin the process of denuclearization “right away” and “there is no longer a nuclear threat from North Korea”. Secretary of State Mike Pompeo also said North Korea will take major steps toward dismantling its nuclear weapons program by the end of Trump’s first term. This is a historic event and will have very long lasting and significant benefits to the US and the global community, should the US pull it off. A denuclearized North Korea will alter US strategy regarding Japan and South Korea from troop counts to annual expenditures. The potential for big defense spending savings is real. More importantly, eliminating the ongoing threats of attack from North Korea to Hawaii and the West Coast, plus avoiding a potential pre-emptive strike against North Korea is a huge win. Lastly, as a rule, it is simply good for the world, and by definition for the global markets, that an authoritarian country will not have nuclear weapons.
The Brewing Trade War: It probably surprised the majority of the market participants including us, that tariffs moved from rhetoric to reality in the 2nd quarter. With the exception of South Korea, negotiations between the US and its broad trading partners have born little fruit to date. What is also surprising, the overall US equity market was barely derailed by the possible trade war, with the S&P500 rising 3.4% and Russell 2K up 7.8% in Q2. It is true the S&P500’s gains can be largely attributable to the good performance of mega cap names such as Apple, Amazon, Microsoft, Google, and Facebook, with the rest of the index’s returns being a wash. However, many energy stocks posted strong returns boosted by high oil prices, and some consumer stocks also delivered double digit returns as the good economy boosts consumer consumption and the fear of a retail apocalypse has largely receded.
Trade tension, however, has caused the Chinese stock market to plummet into bear market territory, as investors voted with their money that in a trade spat or trade war, China will likely be the bigger loser. The math is simple – The US imports ~$500 billion of goods from China each year while China imports ~$130 billion from the US. More over, the Chinse economy is only slightly above half the size of the US and is built on exports. China’s powder is weak, for the amount of American goods they can potentially place tariffs on. Obviously, China can retaliate with other measures, such as engaging in a crackdown on US firms operating in China, pursuing antitrust allegations against big US tech, or simply rallying Chinese consumers to shun away from US products with nationalist propagandas. However, each path entails short and long-term pain for China. While politically China’s current leaders do not have to answer to voters, politics in China is a blood sport, with losers and their families going to jail. Xi has consolidated his power through an ongoing cleanse of opposition, and so long as he delivers economic growth and continues to provide hope for the billions of rural Chinese living in poverty, his aspirations for decades of rule will likely be fulfilled. However, he has made many explicit and implicit enemies in the process and any material disruption to China’s growth targets could have a very negative impact on his reign and physical wellbeing, in our view. China has a GDP per capita of ~$10,000, vs ~$60,000 of the US, and wealth dispersion is much greater in China than here. The consequences of negative growth, enraging hundreds of millions of the poor is a true nightmare for Chinese leaders. Thus while Trump has the pressure of re-election to navigate his trade gambits to open markets and secure public support, Chinese leaders have a very different set of pressures to ensure they have a continued visible path to growth.
Before the dust settles, we will probably see more trade tension rather than a deceleration. We believe President Trump started this trade battle with three issues in mind: the annual $800 billion trade deficit, with China accounting for approximately 50% of it; Chinese intellectual property (IP) theft; and China’s industrial policy known as Made in China 2025. The Trump administration insists the trade deficit with China needs to be reduced by $200 billion a year in the near term. A larger and more difficult issue to understand is the ambitious Made In China 2025 objective that was announced in 2015 and aims to help China become a major competitor in advanced technologies with both commercial and military applications. This initiative will be achieved via heavy state subsidies and regulatory control on foreign entities. Made in China 2025 would allow china to seek greater military and geopolitical power, a direct threat to the US. With no numeric goals explicitly stated, we believe the Trump administration seems determined to deter that effort as much as possible.
President Trump seems to have decided tariffs and even a trade war are the right strategies to achieve the end game – curbing China’s rising dominance in the world while decreasing the trade deficit between the US and China, and other trading partners. This approach has the typical high risk high reward style Trump has acted upon to achieve most of his goals so far. This movie is still being filmed and multiple endings are still possible. Just over the weekend, Trump commented in an interview he is willing to put tariff on imported automobiles, signaling to other countries his resolve in winning this battle and daring them to escalate their actions and rhetoric.
We don’t know when the trade conflicts will be resolved, but the political calculus is probably correct in that if ever there is a time to reset the world’s trade rules, this is the time for the US. First, US economic growth is accelerating and unemployment is at historical lows. Second, the US corporate tax cut is yet to see more of its impact reflected in the US economy, and the US is one of the few developed economies with rising interest rates, making the USD and foreign investments in the country highly desirable. In short, the pain from tariffs will likely be significantly blunted by a growing economy. Should the trade conflict accelerate into a full blown and long lasting trade war, the equation will be very different as the damage will take long to repair. It will take time for other countries to be able to supply the goods to fill the vacuum left by less Chinese imports to the US. On the other hand, it will be even harder for China to find other wealthy consumers to purchase Chinese goods in the quantity and consistency the US has done over the past 40 years. We believe the first win for the US in this battle is to have most barriers to US goods dropped by its EU and North America trade partners. After cleaning up trade policies ex-China, we believe the Trump administration will be in a much stronger position to rewrite how the two largest countries in the world conduct business, as all other countries will benefit from a weaker Chinese government mandating concessions that ultimately put companies in poor position to compete against new Chinese competitors. However, should China clean up its relationship with major US trade partners first, the path for the US becomes less clear. Therefore we believe monitoring progress with US allies in the trade arena will be very telling for the larger resolution with China.
Looking into the third quarter, trade talk will likely continue to dominate the headlines. The US midterm elections will become a more important event for investors to follow. Europe’s stress on the migrant crisis, and whether a final resolution can be reached among its members in particular with Germany, will impact EU’s stability in the foreseeable future. The Fed remains a key influencer of the market, though investors seem to be happy with the actions and communications the Fed has conducted so far. Lastly, Mexico electing Andrés Manuel López Obrador to be the new president with a landslide is moving the country sharply to the left. Mexico will likely chart a more independent course from the U.S. and ally with leftist governments around Latin America, which could be a major negative to North America in the mid to long run.