Either Trump and Xi reach a temporary truce and start negotiations sending stocks higher, or the trade war escalates and market move lower, perhaps to a new correction low. The odds favor the former but the risks of the latter aren’t trivial.
After a very tough Thanksgiving week with stocks down about 4%, markets have turned around this week on the heels of strong Black Friday and Cyber Monday retail sales. Markets are also anticipating that the Trump/Xi meeting scheduled during this week’s G-20 meeting will result is a less combative tariff/trade environment.
As I have outlined before, there are three major events happening between now and mid-September. For markets, the most important one is the G-20 meeting. The consensus expectation is that Trump and Xi will meet on friendly terms and exit with a handshake and a commitment to work together to solve trade and other issues. Depending on whether anything of substance happens during their talks, Trump may or may not go forward with a plan to raise tariffs on approximately $200 billion of goods in January. The extremes that any actual substantive agreement will emerge or that Trump will be so dissatisfied that he will announce 10-25% tariffs on everything China exports to the U.S. appear to be low. The least likely outcome is anything resembling a formal agreement.
Remember that the big issue revolves around forcing China to respect intellectual property. The country has been stealing it in some manner for decades. The country has very ambitious growth goals between now and 2025 and the easiest way to get there is to piggyback on the intelligence of others. President Trump looks at the world as a zero sum game. Every dollar that flows to China or is used to buy Chinese goods is a dollar not spent on U.S. products. It’s. “I win; you lose”. There isn’t a world where everyone wins.
We also know the following about Trump. He has a huge ego and likes world leaders to stroke it. Xi knows this and persistently tries to make Trump feel that he is China’s greatest ally. Trump likes strong leaders whether they be Xi, Putin or even Kim Jong Un. But, at the same time, he’s not completely blinded. He knows China has been abusing our intellectual property for decades. Ending those abuses are a key part of his agenda. Trump keeps score. He wants to fulfill all his campaign promises. He isn’t so naïve to believe China will suddenly fall in line with policies of the developed world but he needs to show movement in that direction. Xi’s job is to allow the perception of progress to happen while still being able to do business the Chinese way as much as possible.
It took almost two years to get a NAFTA rewrite done and it is still a work in progress. A Chinese agreement will be a lot more complex. Robert Lighthizer, our trade representative, is a no nonsense guy. No one is going to stroke his ego. With that said, the NAFTA rewrite isn’t a bold change from the original plan. It is merely an update. Any China deal will be much more complex and will take at least most of 2019 to solve. The issue for markets is how much hubris will markets have to deal with before there is any agreement. We all know Trump’s strategy by now. He starts with fire and brimstone, pauses with a smile or two, restarts to war of words, and backs away again. This week, he was talking tough promising tariffs on everything if China didn’t capitulate by this weekend.
As I noted above, the most likely outcome is for a handshake and genuine cooperation to move talks forward. But if Xi overplays his hand and doesn’t offer to put any serious discussion of intellectual property or open markets on the table, Trump could easily leave Buenos Aires angry and start up the fire and brimstone speech again promising tariffs of 25% on $200 billion of goods in January with more to come.
The reason that isn’t the consensus outcome is because Trump looks at the stock market as a barometer of the economic success of his administration. Right now, the market doesn’t look so hot. His response is to lash out at the Federal Reserve for raising interest rates. But unlike how he tries to sway the American public on issues like immigration, financial markets react to facts and forecasts. Markets now are in decline because they perceive growth decelerating and inflationary pressures rising. Adding an escalating trade war to that mix will only send the market lower. But, and this is a minority view, he could wake up Sunday and go back toward fury if he feels he isn’t getting to first base with Xi knowing that he still has time to pull back from the brink between now and January when the next installment of tariffs would be set to go into effect.
One should remember that recent multi-national conferences haven’t gone all that well for Trump who has become more isolated from world leaders. The recent NATO meeting and the World War I remembrance are to recent examples. Each time he comes home mad, he reacts. Thus, this week’s G-20 meeting is a binary event for markets. Either he makes temporary peace with Xi and markets react positively or he comes home mad and markets move lower. Investors can gamble on the outcome or they can standstill and react to the outcome. Against that backdrop, remember that we are in a decelerating phase of our economy with a strong dollar backdrop, both unfavorable for stocks. With that said, one could make a case that by now, markets have priced in some degree of deceleration next year, long term interest rates have stopped going up, and a slower growth rate could push the dollar lower.
The other two events coming soon, the OPEC meeting next weekend, and the FOMC meeting in mid-December, seem to have become less important. Virtually everyone now expects OPEC to pull back on production after having raised it anticipating U.S. sanctions on Iran that never happened. OPEC wants to stabilize oil prices near the current $50 level. With that said, as U.S. oil production increases, OPEC has less control over oil. From now on, market forces will dictate oil prices more and more. The world knows where there is enough oil to meet demand. Price trumps output. By that I mean, Saudi Arabia or Russia can’t adjust output enough to compensate for a 20%+ drop in oil prices. As for U.S. producers, with prices now near $50 at key shipping points and prices closer to $40 at the Permian wellheads, there is bound to be less drilling in the months ahead. Slower production growth will stabilize prices and probably even move them up a bit between now and Memorial Day. Indeed, if you look at the last 5 years or so, there seems to be a ceiling near $75 WTI and a floor of about $40. Movements above and below those levels aren’t sustainable. High prices invite too much production and low prices will halt new investment.
The last event, the FOMC meeting, will almost certainly seen the Fed raise interest rates by 25 basis points. The only way that won’t happen is if Trump leaves the G-20 meeting promising massive new tariffs sending financial markets into a tailspin. But, at the same time, the Fed is likely to emphasize that, going forward, any further increases will be data dependent. That doesn’t mean that there won’t be any. The Fed will watch carefully for rising inflationary pressures and be quick to raise rates further if those pressures rise or if growth accelerates to unsustainable levels. Similar remarks have been made by various Fed officials this week and such an outcome is probably baked into stock and bond prices today. 10-year Treasuries are very stable at the moment around 3.05%, down about 20 basis points from a recent peak. Perhaps the most important remaining input for the Fed before its mid-December meeting is the December 7th release of November employment data. The Fed will be watching both the size of the job growth and wage inflation data.
Thus, the next few days are key to the market’s near term performance. Either trade becomes front and center with greater confrontation between China and the U.S., or everyone exiting smiling and the pressures recede, at least for now. This weekend’s meeting is a binary event. Either this week’s rally gets extended or quickly erased. We will know soon. Regardless, stocks at the moment trade slightly below fair value. That means I wouldn’t be real enthusiastic to buy a post G-20 rally but would look at my shopping list if the market takes another leg lower should Trump come home mad.
Today, Jon Stewart is 56. Singer Randy Newman is 75.
James M. Meyer, CFA 610-260-2220
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