During a recent conversation with PLANADVISER, Bob Browne, chief investment officer, Northern Trust, said the trade tensions between the U.S. and China are shaping up to have a long-term influence on global economic potential.
As Browne explains, the U.S. in particular feels there is a need for fundamental change in the economic relationship between the two major nations, and clearly the political leadership in China feels that way to some extent as well. Interestingly, Browne says, observers and analysts have both over- and under-emphasized the importance of the trade tensions.
“We think that the result of the tension will be an ongoing, episodic exploration process where both sides are carefully seeking out areas of agreement in a broad context of disagreement,” Browne says. “Full peace is unlikely. A return to where we were before this flare-up is unlikely, but on the other hand this does not mean all-out economic war will happen. It’s very possible there will be an armistice reached, if you will.”
Indeed, President Donald Trump has shown a willingness to delay tariffs on some goods, both because it suits him politically and because it benefits certain parts of the U.S. economy.
“That’s when both sides will come together—when it is in both of their interests,” Browne suggests. “Looking forward, the U.S. is less likely, if not totally unlikely, to put aside its own interests in order to play its former role as the center of global trade with China. It’s not going to play that leadership role anymore.”
Browne says political and economic leaders in the West are coming to an important realization as a result of the ongoing trade tensions. After a long time spent assuming the Chinese economic system would inevitably come to resemble that of the U.S. and Europe, there is no longer much belief that China will undergo fundamental change towards true free market capitalism anytime soon.
“The U.S. leadership has come to understand this,” Browne says. “That belief won’t change whether President Trump wins a second term or whether someone else comes into office. It’s the new reality.”
In terms of how much visibility investment managers have into the level of pain each side is feeling from the trade tensions, Browne says the impact in the U.S. has been well-reported. On the other side of the Pacific, there is also clearly pain being felt, though the picture is naturally a little murkier.
“There are estimates that 5 million jobs have been lost so far in the China manufacturing sector alone,” Browne observes. “That gives you an idea of the scale of the workforce over there when you cite a number like that. The Chinese equity markets have been under pressure, too, after starting off well in 2019. These things also reflect the slowdown that was already structurally occurring in China, just based on the simple fact that you can’t have 10%-plus GDP growth once an economy gets to $13 trillion.”
Global Implications and the Yield Curve
According to John Lynch, chief investment strategist at LPL Financial, and Callie Cox, a senior analyst with the firm, it is also important for investors to note that trade challenges exist beyond the United States and China. In written commentary shared with PLANADVISER, the pair notes that the United States’ pacts regarding NAFTA 2.0, South Korea and Japan, and European automobiles are still unresolved.
Browne agrees with this assessment. “Also worth noting is the unintended victims we are seeing in Europe, which is much more export oriented,” he says. “The poster child for this is Germany, which is heavily depending on its export sector. The challenges in Germany show the global nature of this tension and how all countries are having to address these issues. Export-driven business models are readjusting, and that is meanwhile leading to the slower growth we have been seeing and projecting.”
Stepping back, the LPL analysts suggest that, despite a decade’s worth of global monetary policy accommodation, very few inflationary pressures are evident in this environment, presenting leading central banks with the need for further accommodation.
“We recognize the danger of printing these words, but the current environment is profoundly unique,” the pair writes. “Typically, economic cycles end as inflation climbs, and the Fed responds by tightening policy, leading short-term rates to increase faster than longer-term rates, inverting the yield curve, and portending recession.”
The present situation involves falling commodity prices, below-target inflation, an accommodating Fed, and a firm U.S. dollar.
“A variety of geopolitical risks have pushed ‘safe haven’ investors into Treasuries, despite sound fundamentals and the rising budget deficit,” Lynch and Cox suggest. “Consequently, the current yield curve inversion is characterized by long-term rates falling faster than short-term rates, increasing investor fears of imminent recession. In the last three economic expansions, the U.S. economy peaked about a year after the 2-year and 10-year yield spread inverted for 90 days straight. Since the spread between the 10-year Treasury and 2-year Treasury yield has been negative only occasionally over the past few weeks, we suspect the message really is that Fed policy is too tight for current trade uncertainty.”
The pair concludes that after a record expansion, the U.S. is bound to have recession sometime. Timing when the recession may come, however, is a huge challenge and likely not worth the effort.
“Right now, economic fundamentals suggests the consumer remains sound, and any clarity on trade potentially can boost business investment, possibly supporting productivity growth and elongating the expansion,” Lynch and Cox write. “However, prolonged trade uncertainty and a potentially rancorous U.S. election campaign leads us to wager a one-in-three chance that businesses and consumers decide to ‘sit this one out’ in the fourth quarter of 2020 and the first quarter of 2021.”
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