Overnight, the value of the Chinese yuan fell to a ratio of over 7 to the dollar for the first time in over a decade. As a result, equity markets worldwide accelerated their declines. Future markets point to losses of over 1% at the open.
Let’s start by reviewing last week’s chain of events. First, the Federal Reserve cut its key lending rate, the Federal Funds rate, by a quarter point on Wednesday. While markets reacted negatively immediately after the rate cut as Fed Chair Jerome Powell failed to promise additional cuts at future meetings, investors calmed down overnight and by mid-day Thursday, had recovered all the losses of Wednesday afternoon. But then around 2 pm, President Trump tweeted that he planned to increase tariffs on Chinese goods on September 1 since the Chinese were not moving quickly enough in his view toward a trade package he wanted. Moreover, China was not buying U.S. agricultural products in the quantities he thought they had committed to buy. Stocks fell immediately. Tariffs are a tax. They slow the pace of commerce and stifle growth. But by Friday, markets seemed to have calmed down. While markets finished lower for the second straight day, losses were pared in the afternoon and trading volumes slowed as one would expect for a summertime Friday.
But the currency moves over the weekend have set markets in motion again. There is no evidence yet that China intervened directly in the currency markets to force the yuan to fall against the dollar. Indeed, the natural reaction would be for the yuan to fall as the tariffs are aimed at hurting the Chinese economy. A weak economy leads to a weak currency as a counterbalance. The tariffs put China at a disadvantage; a weak currency would restore some of that disadvantage.
President Trump, even before last week’s threat to add more tariffs, has been complaining that many currencies around the world were weakening against the dollar and that was a headwind to U.S. growth overseas. A strong dollar or a weak yuan, euro, pound, etc. means that our exports become more expensive and imports to the U.S. would be cheaper. If we import more (at lower prices) and export less, that increases our balance of payment deficit. So does the fact that we are growing faster than most other nations. Faster growth means we import more and export less.
Anyone who has followed Trump’s economic logic knows (1) he wants a positive trade balance between the U.S. and every other nation if possible, and (2) he feels tariffs are his best weapon to achieve that. So far, that doesn’t appear to be working. He has actively imposed tariffs over the past two years and threatened many more. But our trade imbalance continues to increase despite the fact that we have become a much bigger exporter of energy resources.
As the old Chiffon margarine commercial said, “It’s not nice to fool Mother Nature!” Currency markets work like a balance scale. A weak currency allows economically disadvantaged nations to compete. Why don’t all countries, therefore, chase a weak currency policy? That’s a bit like asking why don’t all countries try to be weak competitively. It’s counterintuitive. Of course, the Treasury could interfere by buying or selling currencies to artificially change exchange rates but (a) that’s expensive and (b) such an effort cannot be sustained indefinitely.
Regardless of what I have just said, China, historically, has intervened to keep its own currency relatively stable on international markets. It did so principally by buying yuan. Letting the exchange rate fall to a level higher than 7 to the dollar would, in Chinese eyes, offset part or all of the economic impact of the proposed 10% tariffs. In theory, that could mean that U.S. importers would pay less for the goods we import and, even after tariffs are raised and passed through, at least in part, there would be no impact to the U.S. consumer. That doesn’t seem bad on the surface but that ignores the interlocking of all things economic and all financial markets. While the fall in the yuan may balance out pending tariffs, it means earnings of U.S. companies in China get translated back into fewer dollars. It means the price of oil and other commodities fall. It puts China at advantage against the rest of the world that isn’t in a tariff war with China. It puts China at an economic advantage against the rest of the world. Currency markets are far larger than bond or stock markets. Gains and losses in one affect what investors do in others. Getting back to the Mother Nature quote, we are now seeing the consequences of warm weather in so many different ways. Sharks are roaming beaches farther north. Mosquitos flourish. Some species become extinct. Currency markets work best when left alone.
Mr. Trump was tempted to intervene just a few weeks ago before a majority of advisors talked him out of it. I have no idea what his reaction to the weak yuan will be but, clearly, he won’t be happy. When he is mad, he is in danger of doing something impetuously and that is a heightened market fear this morning. Everyone expected the Chinese to retaliate against the threat of added tariffs. So far, the tariffs haven’t been implemented and China has not overtly interfered in currency markets. But if Trump implements the tariffs with promises of more to come, the Chinese don’t behave to his wishes and if both countries start to intervene in currency markets, no one can tell the actual outcome but all can conclude that the end result won’t be good for any financial market except possibly gold.
Tariff wars are more spats than wars. They don’t tend to be long lasting precisely because, in the end, they almost always do more harm than good. Bond yields are declining this morning once again as traders presume moves in currency and the threat of tariffs will result in lower economic growth. Thus, while lower rates could portend higher P/Es, they also mean lower earnings, particularly for multi-nationals. This morning, the President has already accused China of currency manipulation. That almost demands a response soon. This morning, his attention will be diverted to the twin mass shootings over the weekend, but he watches markets and won’t like what he sees. The problem is his next step is more likely to aggravate the situation than alleviate it.
We have gone more than 8 months without so much as a 5% correction. Stocks were already at the high end of their valuation range before the latest news hit. I suspect we are headed for at least a 5% correction here and it could be 10% or more before all is said and done depending on what further actions (and missteps) take place. I don’t think 10% tariffs on Chinese imports ends the economic recovery but it could leave the stock market in a bad mood for several weeks.
Today, Loni Anderson is 73. Maureen McCormick turns 63. Comedienne Selma Diamond is 99.
James M. Meyer, CFA 610-260-2220
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