Author
Author

Michael Stritch, CFA

Chief Investment Officer and National
Head of Investments - BMO Wealth Management.
Author
Author

Yung-Yu Ma, Ph.D.

Chief Investment Strategist - BMO Wealth Management
June 04, 2019
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June 04, 2019

“If we made a deal I could imagine Huawei being possibly
included in some form of or some part of a trade deal.”
– President Trump, 5/24/2019

President Trump is being tested. The trade war with China is raging, future trade issues with Europe and Japan remain on the table, and progress on a domestic infrastructure spending plan is stalled.

Our Current Market News issued May 9, discussed the about-face that took place just as U.S.- China trade negotiations neared the finish line. Since that date, a Chinese negotiating team came to Washington, held the line on the backtracked Chinese positions, and returned home with nothing new other than passport stamps. As President Trump promised, tariffs that were previously set at 10% on $200 billion of Chinese imports increased to 25%. China promptly retaliated by placing tariffs on another $60 billion of U.S. imports.

Tension between the two superpowers further escalated as the Commerce Department put Huawei, the world’s largest telecom equipment company by revenue and a leader in 5G wireless technology, on a list of firms that American companies are prohibited from doing business with due to national security concerns. While Huawei indicated it has stockpiled inventory, and there is a 90-day reprieve from the ban lasting through August 19, the implications are broad and potentially crippling to one of China’s largest companies. Despite this pressure, China is very sensitive to perceived bullying, so whether President Trump’s recent gambit makes an eventual agreement more or less likely remains to be seen.

Looking ahead, the next big event on the trade negotiation calendar is the G20 summit in Japan on June 28 and 29 where President Trump and President Xi could have a personal meeting that cools tensions and enables trade negotiations to resume. However, the reality remains that the prospect of even a partial deal has diminished. China clearly made a calculated decision when backtracking on previously agreed-upon positions. Furthermore, in response to the Huawei ban, China’s Ministry of Commerce spokesperson called for the U.S. to “adjust its wrong actions,” as a precondition to continuing trade negotiations.

While China can set in motion fiscal and monetary stimulus in the time it takes to lift a telephone receiver, the U.S. has an independent Federal Reserve and more lengthy process to approve and fund fiscal stimulus. Previous bipartisan optimism on an infrastructure spending deal hit the skids on May 22, as President Trump reportedly cut short the meeting and was unwilling to push ahead with
an infrastructure plan in the face of ongoing investigations and attempts to obtain his financial records. Senator Lindsey Graham recently appealed saying, “Mr. President, don’t let these guys goad you into not doing good things for the country.”1 He might have also added, “And what's  good for your coming presidential campaign.” It’s hard to imagine the Democrats agreeing to the president’s precondition of ending investigations, so any progress on infrastructure spending would require the president shaking hands with the people leading the charge against him in other areas. It’s either come to terms with that dissonance or simply wait.


Amid these international and domestic disputes, the stock market has pulled back and economic data shows slowing momentum – both the recent industrial production and durable goods reports missed headline expectations and had little cheer buried in the details. Optimism among small businesses is at the lowest point since Trump was elected (see Figure 1). A few percentage point depreciation in the Chinese Yuan has offset a bit of the tariff increase for China, but fortunately for now the Yuan remains below the Q4 2018 lows relative to the U.S. dollar. A deeply weakening Yuan would likely pull down other emerging market currencies and damage the liquidity conditions in those areas. China hopefully also sees steeper Yuan devaluation as too risky, and is likely to come back around to its own shores via slower growth.

Figure 1 - NFIB Small Business Optimism Index

 

So where does that leave us? Our enthusiasm for the U.S. and emerging equity markets is intact, but is less than when trade negotiations looked squarely on track. The market has also taken note of the heightened uncertainty, but may not have accounted for the potentially damaging scenarios where the trade war leads to a sharp slowdown in business spending and a divided global
technology industry. On the positive side, the U.S. job market remains strong, and with core inflation still low, the market believes that the Federal Reserve will be coaxed into cutting rates by year end (see Figure 2). Additionally, our BMO Composite Equity Valuation Metric does not indicate an overvalued U.S. equity market (see Figure 3). For China, despite a large run-up of debt in recent years, the
capacity for continued stimulus looks viable and likely. In summary, while we view the overall economic backdrop as balanced, policy risk is heightened and could further strain the market in the coming months. With this in mind we are advocating a more neutral stance on equities until the geopolitical picture becomes clearer.

Figure 2 - Market-Implied Probabilities of Fed Rate Action by end-of-year 2019

Figure 3 - BMO Composite Equity Valuation Metric - Percentile Valuation

 

1Lindsey Graham on Fox News, 5/24/2019.

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