All anyone can talk about these days is the brewing trade war between the US and China. With good reason. Both of these countries are the two largest in the world, and combined, account for nearly half of the global nominal GDP. So let’s take a quick dive and explore what has happened so far, what it means, and what could happen next.
Overview
Since the Global Financial Crisis in 2008, the US has been on the second longest expansion run in history, and is on track to break the record run set in 2001. This has been possible due to massive quantitative easing enacted by the Federal Reserve to stimulate growth post-crisis with rock bottom interest rates. This bull run has seen the S&P 500 Index touch a record high of 2873.77, albeit with a sharp correction in the beginning of 2018 sparked by increased volatility and concerns the expansion might be ending. Sentiment for the first half of the year has been hit by Trump’s protectionist rhetoric and increasingly escalating trade war with China. Markets have alternated between risk-off and risk-on moods signaling the uncertainty surrounding Trump’s approach to trade policy. The tax cut enacted in December has helped corporations report record earnings in 1H2018, but it remains to be seen if such expansionary fiscal policy is wise at such a late stage of growth. Low unemployment at 3.9% attests to the strength of the US economy, and moderate inflation at 2.9% points to a low to moderate risk of overheating for at least the next year or two.
Theme 1: Trade War with China
Since firing the first salvo in March by signing steel and aluminum tariffs into effect, Trump has escalated his trade war with China in a series of tit-for-tat moves that have sent markets around the world into turmoil. An initial $50 billion worth of goods from China was targeted, followed by $100 billion after retaliation from China. Negotiations mostly fell through, followed with threats of tariffs on an additional $400 billion worth of goods, with another $34 billion coming into effect most recently. It is unclear so far how much the tariffs have affected local industries, but some cracks are starting to show.
Prices for US Steel have skyrocketed since tariffs went into effect. The US midwest hot-rolled coil steel price, which is the US steel price benchmark, has increased from $669 to $912 in a span of 7 months, an increase of 36%. Naturally, prices of goods made with steel has increased as well. As a result of the tariffs, prices for finished goods increase for consumers, employees lose their jobs, or both events occur. This knock on effect will take time to reverberate through the economy, with goods like soybeans being hit as well, but most economists agree that the drawbacks far outweigh the benefits, with losses in jobs and a drag on US GDP growth to come.
The most recent talks between the US and China again ended without much in the way of progress, increasing the likelihood for further tit-for-tat tariffs and putting a trade resolution further out of sight. This, however, seems largely in line with the Trump’s administration’s ultimate goal of curtailing China’s rise especially with regards to the ‘Made in China 2025’ objective. It is likely that the trade war will escalate, as Trump sees the US in a position of strength with its robust growth, and he is expected to push harder, while China has seen growth slow in recent years.
Theme 2: Rising interest rates
The latest Fed meeting in June saw the pace of rate hikes more or less unchanged with the only adjustment in 2019 with a median from 2.875% to 3.125%. Rates are still expected to settle around 2.875% by the end of 2018, with the next rate hike likely coming after the meeting in September. With the slight change in 2019, three to four rate hikes are highly probable next year while over the long term, the median consensus from the FOMC members is around 2.875%. One member shifted the estimate from 2.25% to 2.5% compared to March 2018, indicating two more rate hikes for the rest of the year to come.
Jerome Powell, the Fed chair, said the gradual pace of tightening will likely be appropriate in accordance with the performance of the US economy. While employment is at a record low, the inflation rate is only slightly above the long term target of 2%, which demonstrates the only moderate risk of an overheating economy. However, maintaining inflation would likely now be the primary objective, while avoiding jeopardizing growth of the US. A risk of the expected rate hikes would be the current turmoil in emerging markets where the rise in interest rates have seen EM currencies slide against the US dollar. While Powell has recognized the impact of tightening in the US has had, he has indicated US monetary policy will not depend on foreign markets, but chiefly on the performance on the US economy.
However, we cannot ignore the combined threat of trouble in EM markets, trade tensions and as we will discuss, political trouble in the US. It is likely that the hikes will proceed as expected, but with more caution ahead as the Fed takes a slightly more dovish stance in light of recent developments.
Theme 3: Trump’s trouble
Since Trump’s inauguration, the S&P has risen by an annualized rate of 20%, firms in the US have reported record earnings, and it seems like all is well with the economy. Those who predicted his election would have dire consequences on the economy have simply been proven wrong. Yet we cannot ignore the threat of special counsel Robert Mueller’s investigation into Trump’s campaign alleged collusion with Russia. So far, the economy has largely shrugged off most reports and allegations, but the noose is slowly tightening around his presidency.
Already, some of his closest associates at one point of time or another have been indicted and found guilty of various crimes including obstruction of justice, tax and bank fraud or lying to investigators. These include Michael Flynn, Paul Manafort, Rick Gates, George Papadopoulos and his longtime personal lawyer Michael Cohen, who so far seems to have the most damaging information on Trump. So what impact would an increasingly likely impeachment of Trump look like on the economy? We look at impeachments past for some clarity.
When Nixon was impeached in 1974, the S&P index lost 30% that year. However, the market was in the middle of a bear market from 1973–1974 which was exacerbated by the oil crisis. In Clinton’s case, in 1998, the S&P Index kept on increasing, fueled by the internet boom through the end of 1998 and the beginning of 1999. Both cases show contrasting returns.
However, the common thread seems to be that markets react mostly to fundamentals or global macroeconomic developments more than political drama in the US.
The US economy has already largely benefited from Trump’s accommodative policies like the tax cut in December 2017 and his deregulation. Payrolls are on the rise and inflation is mostly on target. Even if he were to be removed and his policies rolled back, which would be very unlikely as Mike Pence would take over the presidency, there may not be any major impact. Markets have already shown extraordinary resilience to Trump’s misbehavior and bullying tactics.
As such, if an impeachment occurs, expect some volatility and a significant sell-off. The USD will depreciate as investors look to markets with political stability and strong performance. This effect would be short term however and would likely recover strongly in light of the economy.
