It Only Takes a Tweet - August 12, 2019

My goal in these weekly commentaries has been to educate, touch on important high-level themes, relay them in a conversational tone, and view events through the narrow lens of the investor. I must admit, when markets and politics collide, that goal of the narrow lens can be difficult. That said, with as much objectivity as I can muster, let’s recap recent events.

On Thursday afternoon, August 1, President Trump unexpectedly tweeted he will levy a 10% tariff on $300 billion in Chinese goods beginning September 1. Most are consumer goods, and the tariff could go higher. His action has no impact on the $250 billion tariffed at 25%.

The language of the tweet had a conciliatory and diplomatic tone (“my friend President Xi,” “look forward to continuing our positive dialogue with China”). Reportedly, his economic advisors opposed the new tariff, but helped craft the language of the tweet.

Why new tariffs?

Trump was reportedly frustrated that recent meetings with Chinese officials didn’t yield progress, and he was miffed that apparent promises by China to buy more American farm products hadn’t been fulfilled.

In turn, China fired back by announcing it will suspend imports of all U.S farm products. Any possible future purchases could be subject to tariffs.

In 2017, U.S. farm exports to China totaled $19.6 billion, just behind #1 Canada’s $20.5 billion, according to the U.S. Dept of Agriculture. Exports were cut in half in 2018. Despite the ban, it seems unlikely China can replace all U.S. farm goods with imports from other countries.

But Monday’s selloff was sparked primarily by China’s decision to let its currency fall by almost 2% vs. the dollar, setting off fears of a full-blown currency war. It’s the lowest level in over a decade (MarketWatch). Unlike most major currencies, which float freely, China closely manages its currency.

A weaker yuan lowers the cost of Chinese imports and raises the cost of U.S. exports. But a yuan that might fall too quickly risks capital flight out of China. It’s a delicate balancing act as its options are limited.

The U.S. response was symbolic. It labeled China a “currency manipulator.”

Uncharted territory

The U.S. hasn’t been in a trade war since the early 1930s, when barriers were raised around the world. Hence, the unknown generates volatility in U.S. and global financial markets.

One fear is being realized – retaliation begets retaliation. For example, in early May, China reneged on important, already-agreed upon terms, and the U.S. responded by raising tariffs from 10% to 25% on some Chinese goods. China upped the ante with new barriers of its own.

So far, the U.S. economy has performed admirably. Consumer spending has been strong. But the farm economy is reeling, and we’re seeing short-term volatility in financial markets.

The status quo has been China’s friend

Why does party A and party B agree to a deal? It’s advantageous to both sides. Think about it.

A homeowner wants to sell his/her house and a buyer wants to buy the house. They haggle, but the deal gets done because both parties have something to gain. Otherwise, there won’t be an agreement. Market conditions typically dictate who receives the most advantageous terms.

China has been a huge beneficiary of the status quo over the last 20-30 years. It has no incentive to change its behavior.

Its economy has grown rapidly, in part, due to its ability to sell cheap goods to U.S. consumers and obtain technology via theft and forced technology transfers.

You see, U.S. companies doing business in China must have a Chinese partner. Eventually, the Chinese partner requires the U.S. firm to turn over proprietary secrets. If not, Chinese officials can make it very difficult to conduct business. U.S. firms usually relent.

Up until now, China has had no incentive to play by the rules. Why should it? Crime pays.

There’s a new sheriff in town

Agree with his methods or not, Trump’s goal has been to change the calculus by ratcheting up pressure on China so that the status quo is no longer beneficial. It’s a high risk/high reward strategy designed to level the playing field.

While China can ill-afford slower growth, Chinese retaliation comes with a price – volatility in financial markets, higher costs for U.S. businesses and consumers, and a weaker farm economy.

Several months ago, I said, “A quick deal that creates fundamental, enforceable reforms is the best outcome for investors. However, that may not be forthcoming. So, what if talks drag on? Or worse, talks completely break down?

“Market volatility would likely ensue any breakdown, as investors attempt to price in slower global economic growth and the potential fallout of any retaliatory barriers.”

How long volatility may last is anyone’s guess. Will China wait out the 2020 election? Or will economic pain force it to negotiate in good faith? Both sides are feeling the heat, and China is being incented to deal.

Final thoughts

Volatility is rarely welcome but is a part of the investing landscape. We’ve seen volatility before, and we’ll see it again. Our recommendations don’t eliminate risk but help manage risk via diversification and place you on the path toward your financial goals.

Thus far, expectations of continued economic growth at home have once again softened the downside. It’s a refrain we’ve seen over the last 10 years.