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Market View

Concerned about the U.S.-China tariff dispute? Here’s what we do—and don’t—know about the situation, and what investors should be focused on now.

 

In Brief

  • Renewed trade tensions between the United States and China have sparked market volatility.
  • What we do know: As of April 3, the two nations had announced roughly $50 billion in contemplated tariffs aimed at a broad swath of each other’s manufacturing bases. The United States said on April 5 that it may add another $100 billion in tariffs, while China said it may consider further measures. 
  • What we don’t know: It is less certain whether these proposed tariffs will actually be implemented, or if they are being used as bargaining chips. Other wild cards include potential responses from other global economies.  
  • What investors should be thinking about now: Focus on the current fundamentals of the global economy, which include broad-based strength, rising corporate earnings, and mild inflation.

 

Following the market volatility fueled by U.S. President Donald Trump’s announcement of aluminum and steel tariffs on March 8, a new round of trade risks emerged in early April, involving an escalating tariff dispute between the United States and China. What are investors to make of this latest development? We thought it would be useful to take a strategic inventory of the known facts, and the possible wild cards, of the current situation. So in this Market View, we will examine what we do know—and what we don’t—about the ongoing U.S.-China trade fight, along with current global economic and market fundamentals. We also will offer some key takeaways for investors amid the headlines.

What We Do Know
Global markets had to contend with some unwelcome policy developments in the first week of April 2018. The trade dispute between the United States and China ratcheted higher, with a fresh round of proposed tariffs and increasingly heated comments from both sides. The heightened trade rhetoric first emerged on April 3 when the United States proposed a 25% tariff on some 1,300 Chinese goods ranging from medical equipment to dishwashers. The proposed U.S. move was seemingly a response to claims of intellectual property theft by China and, in particular, worries about Chinese state-sponsored cyber-espionage that has zeroed in on the U.S. technology sector. On April 4, China retaliated by targeting 106 high-value American exports, including cars, planes, and soybeans. According to a Wall Street Journal report, each of these proposed moves would affect roughly $50 billion worth of exports (based on 2017 trade) if enacted.

News of these proposed tariffs initially sent markets into a frenzy, with U.S. equity futures declining dramatically in aftermarket activity on April 3. However, comments from President Trump’s new Chief Economic Advisor Larry Kudlow, asserting that these moves absolutely do not represent a trade war and assuring the public that back-channel talks were indeed occurring, seemed to settle investors, with U.S. markets finishing higher on April 4.

The relative calm was short-lived. Late in the evening Washington time on April 5, the Trump administration floated the idea that it would consider layering on an additional $100 billion in tariffs on Chinese goods. On the following morning, China threatened retaliatory countermeasures that “don’t exclude any options.” This is a potentially significant point, as the $150 billion in proposed tariffs by the United States exceeds the $130 billion in goods that China imported from the United States in 2017 (based on U.S. Commerce Department data), implying that the Chinese government would have to take a different approach to match the economic impact of the proposed U.S. move. Major U.S. indexes fell sharply on April 6.

While the recent developments have heightened investor concerns, we are not yet in unknown territory when it comes to global trade. According to Lord Abbett Director of Strategic Allocation Giulio Martini, “trade disputes are normal, while unilateral actions to resolve them are disruptive.” This last point is important: the lack of bilateral resolution to this standoff would eventually affect the equity prices of companies most exposed to the tariffs, as these firms would inevitably face rising input costs or decreased consumer demand. In addition, globalization has inextricably linked supply chains, which makes it impossible to directly target one country in a trade dispute without affecting others. This could create spillover effects, resulting in economic pressures beyond the two main actors in the tariff dispute.

What We Don’t Know
As made clear by Kudlow, the U.S. and China are not yet in a “trade war.” So far, the proposed tariffs are just that: proposed tariffs, and the additional $100 billion in levies floated by the White House on April 5 are also entirely notional at this point. It is impossible to know if the dispute will dramatically escalate into an all-out trade war, and speculating one way or the other is counterproductive. Among other factors that remain unclear as of this writing:

  • On the surface, this current round of proposed tariffs appears intended to bring the parties to the negotiating table, as made clear in Kudlow’s comments on April 4. But there are no official talks scheduled.
  • The extent to which a full-scale trade blowup may spill over to other global economies is difficult to predict. Such a development may bring added pressure on the two parties to reach a resolution.
  • Should the United States and China sit down to address the dispute, it is uncertain how—or if—it may be settled.
  • Under normal circumstances, rational economic actors should be motivated to reach a negotiated solution for the betterment of all parties. But internal political developments in both nations, such as the upcoming mid-term elections in the United States, may change that calculus.

It may take a prolonged period before a resolution is reached. Conversely, the considerations above could lead to quick developments in a number of directions.

What Investors Should Keep In Mind
Obviously, in the coming weeks, market participants will be weighing the current facts of the trade dispute—and carefully monitoring the “X factors” listed above. Yet, we think that the most important thing for investors to keep in mind is that the overall global economic and market environment remains quite strong. It is these fundamentals, more than anything else, that are the most powerful drivers of long-term returns.

To start, the earnings backdrop around the globe continues to be markedly positive as both earnings momentum and revisions have improved over the course of the first quarter. The U.S. equity market has seen the greatest amount of earnings strength (as illustrated in Chart 1) but most major markets have seen momentum and revisions to profit growth forecasts above their long-term averages.

 

Chart 1. Analysts Have Increased Their Earnings Forecasts for Most U.S. Sectors in 2018
Forecasted earnings growth for sectors in the S&P 500® Index for 2018 as of the indicated dates

Source: FactSet.  For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Past performance is not a reliable indicator or guarantee of future results.
Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

 

Against this very favorable backdrop, one positive byproduct of the stock market’s recent volatility is that equity valuation multiples have begun to trend back towards their long-term averages. U.S. equity forward price-to-earnings (P/E) ratios are about 11% off their recent peaks, while global equity multiples are about 10% lower (see Chart 2).

 

Chart 2. Global P/E Ratios Have Moved Back Toward the Long-Term Average
World equity market one-year price-to-forward earnings multiple, March 31, 1994–April 3, 2018

Source: MSCI (P/E multiple changes) and Lord Abbett (long-term average calculation).  Data based on the one-year forward price-to-earnings multiple (price divided by 12-month forward consensus expected operating earnings per share) of the MSCI ACWI Index. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Past performance is not a reliable indicator or guarantee of future results.
Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

 

For both U.S. and global equities, improving earnings have increased the ratio’s denominator (the “E”) while recent volatility has depressed the numerator (the “P”). The result is that global equity P/E ratios are at their lowest point since 2016, which may represent a very compelling buying opportunity for long-term investors.

In addition, the inflation environment, despite an unwarranted scare regarding U.S. labor costs in early February, remains benign, as key inflation indexes remain in line with central bank expectations. This, combined with policy stability across the major global central banks—including the much-watched transition of the U.S. Federal Reserve chair from Janet Yellen to Jerome Powell—has allowed for policymakers to remain broadly accommodative, providing a further tailwind to risk assets.

Finally, global growth remains steady following a robust year of acceleration in 2017. While forecasters did not expect growth to maintain that pace in 2018, expansion should continue at a solid clip. An increase in private-sector activity—a factor missing during the early stages of the bull-market this decade—suggests that the world is on sound economic footing for the foreseeable future.

Summing Up
The ongoing trade dispute between the United States and China certainly adds risk to the markets, but it is worth noting that the early salvos in this “trade war” have thus far been purely rhetorical. Rapid escalation would, of course, have consequences, but today’s strong fundamental backdrop provides ample opportunity for the bull market in global risk assets to continue even amid a prolonged resolution to the current trade dispute.

 

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