Economic Outlook for September 2018
Despite strong quarterly corporate earnings in Q2, the on-going US-China trade dispute continues to dominate financial press headlines. This issue remains the major overhang for global equity markets today. The impact so far from the trade dispute has been limited to weaker economic confidence survey data in China, and a corresponding sell-off in Chinese-listed equities. Underlying economic activity has been broadly unaffected so far, including in China where activity indicators continue to show robust growth. The weaker outlook in China is driven by concerns that the trade war could negatively impact Chinese exporters and therefore the Chinese domestic economy could suffer too. Higher tariff costs may simply have to be born by Chinese manufacturers. Meanwhile the US economy continues to power ahead with little evidence of any impact from the trade dispute. It is important for investors to understand the underlying incentives for the US administration to follow this policy. With the upcoming US congressional mid-term elections in November, the issue of global trade has been politicised by the Trump administration. It is likely they want some sort of ‘trade win’ to show the Republican voting base by November. The surprise progress in negotiations with Mexico (and potentially Canada) last week on trade is a strong indicator that beneath the rhetoric, the US President has one eye on concluding this issue.
A slower economy in China is a possible outcome investors should be aware of, it is a short-term risk and the possibility of this happening has been enough to see a sell-off in Chinese equities. This is a manageable risk for investors and one that Dominion has followed closely. As always, short-term risks of slowing business cycles or artificially lower trade activity driven by political risks will always be present in global markets. The world is inherently uncertain. North Korea was very recently thought to pose an existential risk to global markets, while today it receives little attention. As always, investors should remain vigilant of risks and look to adjust exposure where necessary. But this should not distract investors from investing in long-term structural growth trends, which will continue to change the world no matter what short-term risks may come and go. Dominion has since Q1 2018 monitored and adjusted its exposure to trade war risk and fallout from lower growth in China. This has not changed the long-term focus on structural growth trends, which will continue to drive long-term investment performance. Bond markets continue to offer investors little upside, low (even negative) returns and growing price risk. Equity market valuations have actually come down in 2018 with corporate earnings growth exceeding share price increases. A political solution to the US-China trade dispute would certainly boost equity market sentiment in the short-term, but even without this event occurring, the long-term prospects are good for investing in equities with structural growth exposure, strong returns on capital and trading at attractive valuations.
Light at the End of the Trade-War Tunnel?
President Trump’s administration has politicised global trade and, as with any issue that becomes politicised, logical thinking loses to the emotional impulses of voters. In this case, the Trump administration has told its voting base that international trade is a zero sum game, with a winner and a loser in every deal, and that Trump himself will bring back big wins for America from being ‘tough’ on China, as well as on traditional Western allies like Canada and the EU. The truth is global trade is not zero sum; the entire principle of it is that it is win-win and generates greater aggregate wealth for the world. The logical way forward based on reality would be for all parties to focus on constructive trade dialog and ultimately a focus on lowering tariffs everywhere to promote free trade. That is what the WTO and free-trade deals have been doing pretty well for decades. Given the politicisation of the issue, what is more likely is that we will continue to see aggressive rhetoric from the US President, while in the background the countries negotiating with the US will offer concessions that look good to voters in Tennessee, et al. The true cost of these concessions will likely be low relative to aggregate trade volumes or economy size in $ terms. But it will offer Trump’s administration what it has wanted all along; a victory, however shallow, that can be waved around in the political sphere as evidence of Mr Trump’s brilliance. The recent progress with Mexico, where an agreement is alleged to be very close, and the prospect of agreement with Canada as well, offers some insight into there being light at the end of the tunnel on trade. China is getting hurt more than the US by the imposition of tariffs. This makes sense as it has a net trade surplus with the US. Although there may not appear to be any progress as yet, this could change very quickly, especially if China makes the first move. China will almost certainly be willing to offer concessions to end the dispute and equity markets could see a resolution to this overhang faster than is expected.
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