February 21, 2019

White flag flying

“Hoping all your consequences are happy ones.”

Bob Barker, host of Truth or Consequences (1956-1974)


Truth or Consequences was the first game show broadcast on live television on July 1, 1941. Audience contestants “truthfully” answered a trick question or paid the “consequence” of performing a funny stunt on live TV. Today concludes another round of trade talks in Washington to follow up last week’s talks in Beijing. Continued progress is widely expected but without a final deal. So with the March 1st deadline just days away the question becomes:

Will we have a trade truce or will there be consequences?

The truth probably lies somewhere in between but it is important to note that consequences can contain both positive and negative elements.


A March 1 deadline was initially set during the Dec. 1 meeting between Presidents Trump and Xi after which the current 10% tariff rate on $200 billion in Chinese imports would expand to 25%. Now that the Fed has signaled a “pause” for additional near-term rate hikes, trade policy has become the primary concern among most investors. Trade talks appear to be constructive however we now expect an extension of up to 60 days before reaching an interim agreement with China.

Three key reasons for an extension:

  1. Once talks conclude, Presidents Trump and Xi would each like to claim partial victory ending with a handshake at a summit meeting perhaps as early as mid-March for both political and economic reasons.
  2. On Sunday the Department of Commerce submitted its report to justify whether or not the U.S. can cite national security risks in moving forward with auto tariffs on Europe. President Trump has 90 days to respond and likely wants to wrap up things with China before pivoting to Europe.
  3. 2020 Democratic presidential candidate debates begin in June. President Trump likely wants a trade victory without disrupting the stock market before then.

Takeaway: It is highly unlikely that tariffs on Chinese goods rise from 10%-25%. Concessions will be made by both parties with any deal likely to include new timelines tied to benchmarks such as:

  • Chinese commitment to purchase more U.S. goods
  • Opening of previously restricted Chinese markets
  • Reforms for intellectual property rights (potential sticking point)
  • Gradual drawdown of existing tariffs once measurable benchmarks have been met

The most important benchmark of all to the White House is the stock market itself.

Markets respond:

As the chart below shows, the trade dispute clearly resulted in market consequences. Throughout 2018, as the dispute intensified and both parties enacted tariffs, share prices suffered at U.S. firms with much of their business in China. In contrast, since the Dec. 1 meeting between Presidents Trump and Xi, shares of those same companies have done well. In other words, when markets expected a bad outcome in 2018, shares plummeted. As tensions have eased in 2019, hopeful market expectations have lifted share prices. Our base case calls for a compromise deal that in isolation would not meaningfully impact S&P 500 earnings or share prices.

chart of S&P 500 Companies with most Chinese Revenue Exposure Relative to the S&P 500

During fourth quarter earnings calls, a broad cross section of companies addressed top-of-mind themes with trade uncertainty toward the top of the list. This is relevant for two key reasons:

  1. Tariffs directly accounted for roughly 1/3 of the earnings downgrades due to slower China revenue, higher input costs due to tariff retaliations and customer uncertainty. Further deterioration in expectations could risk an earnings recession.
  2. As the chart below from the National Federation of Independent Business shows, 2018 saw a significant decline in firms’ economic and expansion expectations. This softening of business sentiment anchored by trade uncertainty remains an indirect but primary risk. Business sentiment closely correlates with earnings reality so we are watching this closely for signs of improvement or deterioration.

chart of NFIB Percent of Firms Expecting Economy to Improve vs NFIB Percent Reporting Now is a good time to expand

Global Impact:

Talks between the U.S. and China are stealing the headlines, but the potential impact of trade tension or even resolution is global.

USMCA (U.S., Mexico and Canada): Congress has yet to vote on NAFTA’s replacement.

Europe/Japan: Look for a quick pivot to Europe assuming a truce between Trump and Xi by April 15. The European dispute involves tariffs on autos and auto parts. Total U.S. exports to Europe and Japan are more than double U.S. exports to China so the economic risk of retaliation by Europe is significant.

Broad vs. Targeted goods: Any final trade deal with China can have a significant knock-off effect on other countries as well. The broad makeup of total U.S. exports is quite similar to France, Germany and the U.K. As a result, any broad trade agreement between the U.S. and China that results in purchasing U.S. goods instead of similar European goods, could hurt the European economy. Likewise, if a U.S. China trade deal targets products like soybeans and semiconductors, countries like Taiwan, South Korea and Brazil, who derive a meaningful portion of their total exports from these goods, could feel some pain. This could have asset allocation implications favoring U.S. companies who could stand to benefit.

Bottom Line:

It is unlikely the U.S. gets everything it wants from trade negotiations with China and equally unlikely that no deal occurs. Our base case is that the U.S. and China reach a compromise within the next 60 days and the U.S. quickly pivots to Europe. Tariffs at the current 10% will likely remain throughout much of 2019 and perhaps into 2020. The U.S. will likely offer China the incentive of removing some of those tariffs in exchange for China agreeing to open select markets, purchase select U.S. goods and soften its stance on intellectual property transfer. As investors, the key things we will be watching include:

  • Resolution to the U.S./China dispute could stabilize economic and earnings expectations.
  • Markets supported by high hopes for a trade deal could sell on the news but not below current support levels.
  • A disappointing deal or indefinite delay could prompt markets to retrace some of their YTD gains breaking current support levels and perhaps even retesting the recent correction.
  • A compromise trade deal (our base case) would be a market positive not because it would provide a lasting economic tailwind but because it would eliminate a near-term market headwind.
  • Removing trade as an obstacle could have a cumulative effect when combined with the recent Fed pause to support risk assets later in 2019 but expect a few bumps along the way.
Jeff Terrell, CFA
Chief Wealth Market Strategist

Sources: Strategas Research Partners, Evercore ISI, FactSet, Goldman Sachs Global Investment Research, Morningstar, BCA Research, Standard & Poors

The information set forth herein was obtained from sources, which we believe reliable, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation by us of the purchase or sale of any securities. Diversifying investments does not ensure against market loss and asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns. Past performance does not guarantee future results.