ncertainty over trade policy across the three largest trading blocs (the European Union, US and China) has weakened global manufacturing for the past several months. The unexpected drop in September’s Non-Manufacturing ISM survey, from 56.4% to 52.6%, suggests that weakness in manufacturing is now spreading to the much larger US services sector.
US labor markets remain solid and the unemployment rate dropped to a 50 year low of 3.5% in September. However, unemployment tends to be a lagging indicator and the unemployment rate can continue to fall even after an economic slowdown has begun.
Despite the increasing signs of a global economic slowdown, US equity markets remain less than 3% below their all-time highs. US equity market resilience may be premised upon hopes for a quick resolution of the US/China trade dispute as negotiations resume next week.
White House economic advisor Larry Kudlow helped spur markets higher on Friday by strongly suggesting the possibility for such a breakthrough. A quick resolution of the trade dispute, according to prevailing market consensus, would restore business confidence and allow business investment and the global economy to reaccelerate. We are skeptical that such a “quick fix” for subdued business investment is possible.
We believe that businesses are holding back from making long-term investment decisions because of the collapse of the 30-year trade policy consensus around globalization and increasing global economic integration.
Business leaders have lost confidence that the new trading regime will simply tinker around the edges of the old globalization model (fairer trade with China, soft Brexit, etc.), and need a clear understanding of what the new trading environment will look like before making major investment decisions.
A lasting, long-term resolution to the US/China trade dispute will likely require major changes in China’s economic model and could create a backlash within the Communist Party’s power centers. Unlike the US, China’s economic indicators are stabilizing and even improving thanks to massive monetary and fiscal stimulus (see chart below).
Weakening economic data and an escalating impeachment process could pressure President Trump to make a deal with China. China might conclude that it has the upper hand in these negotiations and doesn’t need to offer the kind of sweeping concessions required to create a viable long-term trading framework.
Business leaders would undoubtedly view a weak deal as better than no deal at all, and US equity markets could celebrate such an outcome by breaking out to new highs. However, we believe that a US/China agreement that fails to require major Chinese structural reform will be viewed as just another temporary trade truce. A temporary cease fire in the trade war is unlikely to be enough to restart business investment or reverse the current slide in global growth.
Market price action over the past several weeks suggests to us that investors are looking for any excuse to buy US equities. We understand this impulse. Investors are confronted with dismal economic prospects in almost every other developed economy and close to record lows for global long-term interest rates, including negative rates across much of Europe. US equities could be viewed as almost the only hope for reasonable returns across the major asset classes.
If President Trump is able obtain a trade agreement requiring sweeping reforms across the Chinese economy, we will enthusiastically join the buying frenzy for US equity assets.
However, while we believe that economic concerns and the impeachment process increase the chances for a trade deal, we do not believe that President Trump currently has the negotiating leverage to force China into making dramatic concessions.
A trade agreement with China could provide President Trump with a foreign policy victory that changes the political narrative away from impeachment and provides more assurance of a strong economy as we approach the 2020 elections.
However, we worry that any agreement acceptable to Chinese leadership will fall far short of the changes needed to establish a healthy long-term trading relationship between the US and China. A temporary trade truce will likely create a short-term market rally but continued sluggish global growth could preclude a sustained bull market, in our view.
In addition to reducing President Trump’s negotiating leverage with China, the slowing US economy and escalating impeachment process create additional political risks for equity investors. President Trump’s signature accomplishment is a robust US economy, and any significant economic slowdown could hurt his reelection prospects.
Former Vice President Joe Biden is by far the most investor friendly of the top tier Democratic presidential candidates, in our view. President Trump’s impeachment defense is focusing a harsh light on the Biden family’s business dealings and could damage Biden’s bid for the Democratic nomination.
Senator Elizabeth Warren is picking up political momentum and concerns about Senator Bernie Sanders’ health could shift some of his support to her campaign.
The potential that the next president might advocate eliminating private health insurance and hydraulic fracking (potentially the equivalent of a self-inflicted OPEC oil embargo) could limit equity market returns and keep markets unsettled and volatile.
We are likely to ignore any market rally resulting from a breakthrough trade agreement. Unless a proposed trade deal requires sweeping economic reforms in China, we believe that any rally will ultimately fade under the pressure of subdued economic growth and rising US political risks. We intend to remain overweight long duration US treasury bonds and keep a high percentage of cash in our portfolio. We expect to put half of the money back to work if we get a pullback to about 2750 on the S&P 500 (March and June support levels). We intend to become fully invested upon a pullback to 2400 (the December 2018 lows).
