The catalysts for this week’s volatility have been strong moves in currency markets set off by President Trump’s threat to impose 10% tariffs on $300 billion of Chinese goods on September 1. China, in response, let the yuan fall to over 7 to the dollar for first time in a decade. The White House responded by labeling China a currency manipulator. China since then has moved to stabilize the exchange ratio at about 7 calming markets for the moment.
Currency markets are by far the largest financial markets in the world. All financial markets are interconnected. Significant changes in any one has ripple effects everywhere. Given the sheer size of currency flows worldwide, even slight changes in exchange ratios can cause outsized movements across bond, stock, commodity and derivatives markets. That is what happened Monday. Yesterday witnessed a nervous recovery. Traders have no idea whether there will be a period of political calm ahead or whether the tit-for-tat war between the U.S. and China will escalate.
On the surface, a decline in the value of the yuan would seem to mitigate some of the economic pressures created by tariffs. A lowered value yuan reduces the pain of a 10% tariff. But that is just the narrow view. Many countries peg their currencies in some fashion to either the dollar or the yuan. Many issue dollar denominated debt. When the dollar gets more expensive, their debt obligations expand. Oil is priced worldwide in dollars. A strong dollar is offset by lower oil prices. Yesterday, as stocks rallied by more than 1%, energy stocks fell. The average oil and gas related stock is down close to 50% year-to-date in a stock market that, overall, is up 15-20%. The damage isn’t all currency related, but the pains of currency, oversupply and tariffs are overwhelming not only to oil and gas, but all commodities. The drop in commodity prices worldwide is reflected in negative interest rates around the globe.
All of this is unnatural. The borrower is supposed to pay the lender for use of the latter’s money, not the other way around. Commodities should trade in a range, not go into perpetual freefall. Tariffs are reducing demand and slowing trade in a world that was already oversupplied. While strength in the consumer sector is keeping most economies in a growth mode, eventually the headwinds just noted could erode consumer confidence and set off a true deflationary spiral.
At the moment, these are all ifs. They are not predictions. But an escalating trade war, or even the threats of more tariffs, ultimately could deflate most economies. President Trump’s economic agenda is built on America first. That is as it should be. Tariffs are his weapon of choice to pressure others to alter policies in a way that favors American commerce. He looks at the balance of trade as a key market of success. To him, a negative trade balance, all else being equal, implies something unfair within the trade rules that causes the imbalance. Others suggest that if we are the strongest trading partner, we will naturally have the greatest demand for imports. Indeed, our trade deficit tends to widen in good times and shrink in bad times. In addition, Mr. Trump is correct in noting that other countries impose greater tariffs on us that we do reciprocally. That is why, for instance, he periodically threatens tariffs against European auto exporters.
But whatever the reason, the clear fact is that tariffs stunt growth. Our growth has declined by about 1% over the past year as a result of tariffs implemented. That does not factor in future tariffs like the 10% expected to be levied on Chinese goods in September. More tariffs not only mean lower growth; they also mean lower prices and less inflation. American businesses have so much excess capacity and so little pricing power that very little of the tariffs imposed flow through to consumers through higher prices.
If there is “good news” in all this, it is that interest rates in our country are in free-fall. The 10-year Treasury yield is now below 1.7%. Low interest rates are a catalyst that promote more risk taking. In the stock market, that means higher P/E ratios. Thus, while earnings year-to-date are flat, stocks are up 15-20% because P/Es have risen as interest rates have fallen. Third quarter earnings are now forecasted to be flat again and new tariffs may lessen expected growth in the fourth quarter, particularly if tariffs are implemented.
Adjusting to all these changes implies elevated volatility. It also suggests that investors may choose to get as far away from the currency and tariff storms as they can. That means continuing to stay aware from commodity businesses, companies highly dependent on China or multinationals exposed to major changes in the value of the dollar. Falling P/E ratios favor growth stocks and falling interest rates put a floor under the prices of companies with high and growing dividends.
Clearly, markets near term will be highly dependent on the news flow. But the relative calm of yesterday may continue for a bit if the saber rattling slows down.
Today, Mike Trout turns 28. Charlize Theron is 44.
James M. Meyer, CFA 610-260-2220
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