After the market hit all-time highs in late April, May marked the return of volatility as trade negotiations with China broke down.
It all started on Sunday, May 5th when President Trump issued a tweet indicating the Chinese had backtracked on already-negotiated promises to write into Chinese law changes covering areas like intellectual property, subsidies, and forced technology transfers. China wanted to issue regulations to support these changes, but in the past regulations haven’t been enough to change behavior. In response, Mr. Trump chose to increase existing tariffs on approximately $200 billion of Chinese goods from 10% to 25% starting June 1st.
It appears the reason for China’s change in position stems from misinterpretation of various comments from the President as well as internal Chinese politics. Mr. Trump has called for interest rate cuts from the Federal Reserve, a request that usually indicates economic weakness. Public comments that trade negotiations were going well and belief that an agreement was imminent gave China the impression that Mr. Trump had to make a deal. Further, hard-liners within the Communist Party resistant to market reform expressed their displeasure at the proposed trade agreement.
Predictably, China responded by increasing tariffs on approximately $60 billion of U.S. goods already subject to levies starting June 1st. The highest rate of 25% targets agriculture products, while the remaining roughly $60 billion of U.S. imports including strategically important goods like Boeing aircraft and crude oil remain tariff free. This response indicates China wishes to raise the political pressure on Mr. Trump, but protect its own economy that is now just starting to recover due to substantial monetary and fiscal stimulus enacted in early 2019.
To ramp up pressure further, the Trump administration has filed to levy 25% tariffs on much of the remaining $325 billion of goods from China not currently subject to tariffs. These moves don’t seem to have fractured relations as both sides are continuing discussions and Mr. Trump and Chinese President Xi Jinping plan to meet at the G-20 summit in June.
The economic impact of tariffs acts as a tax on U.S. consumers and businesses. However, the direct effects on the broader U.S. economy are hard to measure. The U.S. imports roughly $525 billion per year from China, on its face a large number, but when compared to annual GDP of $21 trillion amounts to only 2.5%. The U.S. exports about $125 billion, about 0.5% of GDP. We have seen studies that indicate the implementation of 10% tariffs on $200 billion of Chinese goods last year lowered GDP by perhaps 0.1% or so. Implementation of higher tariff rates will represent a further drag on growth, but the direct effects seem unlikely to push the U.S. into recession as some have predicted.
More difficult to quantify is the impact of uncertainty on trade and investment decisions. Chinese investment in the U.S. has declined this year and U.S. businesses are concerned about losing access to the large, emerging Chinese consumer market and the costs of relocating their substantial supply chain investments if tariffs become permanent. We view the tariffs as a useful means to bring China to the table for structural reform, but not to spur U.S. growth as some have suggested.
Weakness in the global economy and a strong dollar has negatively impacted first quarter 2019 earnings for U.S. companies that do substantial business abroad. According to FactSet Research, with 90% of S&P 500 companies reporting, first quarter EPS has declined 0.5% on a sales gain of 5.3%. However, for companies with greater than 50% of sales inside the U.S. the picture is much brighter, with earnings advancing 6.2% on a 7.3% sales gain. Conversely, companies with less than 50% sales in the U.S. have faired poorly, with earnings falling 12.8% and sales flat at 0.2% growth. These results prove it is in U.S. multinationals’, and investors’, best interests to make an agreement with China that clarifies the role of trade in the global economy.
As for all of 2019, analysts project S&P 500 aggregate EPS growth of 3.3% on a sales advance of 4.7%. The forward twelve-month P/E ratio stands at 16.5, matching the previous five-year average and about 12% higher than the 14.7 observed over the past 10 years. Even flirting with all-time highs, the market isn’t particularly expensive. Further, there is quite a bit of pessimism for earnings growth built into these forward expectations.
Even with global uncertainty, the U.S. economy is performing well. First quarter GDP grew 3.2%, the strongest advance for first quarter growth in four years. This is good news as over the last few years the first quarter has recorded lower levels of growth when compared to the second through fourth quarters, pointing to possible issues with seasonal adjustment factors. However, a concern for the quarter is the composition of growth that favored a strong showing from net exports and some building of inventory versus a weaker showing for consumption, which represents about 70% of GDP.
There is good reason to believe consumers will step up purchases going forward. In April, the economy added 263,000 jobs and the unemployment rate fell to 3.6%, the lowest level since December 1969. Average hourly earnings were up 3.2% year-over-year. When coupled with low inflation, workers continue to get a real increase in wages. The other benefit from low inflation is that it keeps the Federal Reserve from feeling the need to raise interest rates, even in the face of low unemployment.
While trade concerns dominate the headlines, there is reason to believe that a little good news could boost the market further as valuations are reasonable and expectations are modest.
Dan Boyle, CFA