China and Inside Baseball
Jun. 10, 2019 Commentary

China and Inside Baseball

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“We can argue whether Trump is the American president that America deserves right now, but we can all agree that Trump is the President China deserves.”  – Thomas Friedman, New York Times

Many in Washington are now seeing the real purpose behind the Trump-driven trade tariff “war” which has been waged with China. It appears President Trump’s real opponent on the trade front has been China, all along. Now, two commentators who make very strange bedfellows are observing the same side of the trade coin. Perhaps this is the issue that unites both sides of the political isle? Even Sen. Chuck Schumer has recently spoken out and advised Trump to “hang tough on China.”

Trade Issue – Where We Stand – Tariffs are Only One Part of the Issue

Thank goodness we live in the United States. Among the blessings we share is an economy that historically has been more self-reliant than most. The United States contains vast amounts of natural resources, the world’s largest economy, a steady central banking system and a relatively resilient consumer. Compare our economic and political structure to China (communist system with limited personal liberties and limited natural resources), Germany (heavily reliant on export growth rates) and Japan (stagnant systemic growth opportunities). 

We as a nation face a new challenge…the fact that the world’s second largest economy seems to have been acting poorly and attempting to take advantage of the rest of the world. I’m speaking of China’s trade practices. Don’t get me wrong, outside of China, the rest of the world isn’t full of free traders. I include the United States in that statement. Governments around the world imposing tariffs on imports is commonplace. The United States’ combined tariff rate on industrial products of 2 percent -- prior to the changes of the last few months -- is among the lowest in the world, according to the Office of the U.S. Trade Representative. The tariff issue has been brewing for the better part of two years. I have come to the conclusion that the real issue the world has with China has little to do with actual tariff rates, per se. Instead, the real issue appears to be industrial espionage and China’s global expansionary plans over the long term. Therein lies the real topic of the quote above from Friedman.

Two of the more egregious practices which the Chinese government has undertaken during the last number of years have been:

  • To gain access to China’s economy, importers may need to take on a Chinese partner…someone who may be tied directly to the Chinese government. This allows China control over, not only import levels, but pricing and business practices of companies that naturally want access to the world’s largest consumer group.
  • Industrial espionage has been a common practice of various Chinese-based companies backed by the Chinese government. Additionally, foreign companies may be required by the Chinese government to provide access to patent-protected manufacturing processes and proprietary industrial secrets. If companies refuse to comply with these requirements, they may not be allowed to sell their products to the largest population base in the world. Companies that spend years and large amounts of capital developing proprietary products may be obliged to share these secrets with China’s government.

To say the least, these actions are not common practice in most parts of the world. These requirements have provided the opportunity for China’s companies to mimic high-tech manufacturing efficiencies gained through hard work and investments by companies and people from around the world. Therein lies the reason, in my opinion, why President Trump has pushed for higher tariff levels on Chinese imports into the United States. China’s unfair practices have to change for the betterment of the entire world and not just manufacturing firms in the United States.

I am the first to admit that I have been opposed to tariff increases. I am pro free market. Tariffs and trade restrictions are typically anathema to all free market thinkers. In the past, I’ve expressed my concern of the problems increased tariffs may bring upon our economy. I’m convinced the world needs to do something regarding the assertive actions of China’s central planners, who have become much more aggressive in their ambitions.

While it’s not wise to overstate the severity of a problem, China’s President Xi appears to have strong desires to expand China’s global influence. Along with aggressive trade practices, China’s Belt and Road Initiative (BRI) holds real risks for the world as a whole. If China is not held accountable for their unfair trade actions, then the world may eventually have to pay a dear price. With a serious expansion in both economic and military desires, China may be a real menace with which the free world will have to contend.

I stand on the view that while inconvenient, and perhaps painful, something has to be done in an attempt to bring China’s abusive trade/economic/expansion policies under control. It seems the United States is the only country large enough to address this issue. Our actions to bring China to account for their aggressive policies would certainly be more productive if other major traders with China would join the effort, such as Germany, Japan and the United Kingdom. That isn’t going to happen easily. These three countries are currently more focused on staying out of their own recessions or dealing with politically based problems.

Expected Economic Impact – Slower Growth, But No Recession  

Now that the tariff tit-for-tat process between the United States and China has entered the second round, it’s becoming obvious that a trade war between the world’s two largest countries has indeed started. What kind of economic impact may the new round of tariffs impose on both the United States and China’s 2019 economic growth prospects? The International Monetary Fund believes the more recent increases will negatively impact both countries’ economic growth prospects by about .5 percent and 1 percent  respectively, assuming that the current new tariff rates stay in existence for the remainder of this year.

If this presumed level of growth impact is reasonable, the U.S. economic growth rate, according to many forecasters, will be around 2 percent this year and China’s should be around 4.5 percent (real, not announced by Beijing). It’s important to understand that given the current tariff rates, we still believe the United States – and the world – should stay out of recession this year (and the U.S. stock market stays away from the bear market).

Next Round – Is it Coming?  

There remains about $300 billion of annual Chinese imports into the United States that haven’t been affected by the tariff war…yet. Will the Trump administration apply the new 25 percent tariff rate to these imports? We don’t know, but, by most accounts, the Chinese authorities are not backing down on their practices that we, and much of the rest of the world, want addressed. The not-yet-affected imports amount to about half of all imports from China; the United States still has significant firepower to apply further pressure to China’s exports to our country.

If put into effect, what impact may these new tariffs have on the overall economy? Prospectively, we should expect a slight increase in inflation along with slower overall growth in consumer discretionary spending. Perhaps the biggest impact may be on both consumer and business sentiment. Over the last six months, business sentiment has weakened, both on the small and large business sides. 

Bringing This Home

The economic and capital market risk resides in expanding the discussion on the trade issue away from tariff rates (which is low hanging fruit) toward trade practices including industrial espionage. If the discussion moves in that direction, this may put the Chinese in a position in which they can’t solve the problem and save face. If that happens, the trade problems may last for some time. That is the downside.

If the next, higher rate of tariffs are announced by the Trump administration, some are suggesting the U.S. economy may indeed fall into a recession. I believe it’s too early to make this call, but certainly economic risks would rise due to this round of tariff adjustments. If this were to occur, I suspect the Federal Reserve would move fairly aggressively toward monetary ease by lowering interest rates and possibly launching a new round of quantitative easing (QE) policies. All of this is currently speculative and further off in the future.

In the meantime, the uncertainty of the trade issues affects capital market price volatility levels. We expect to see further periods where asset value price volatility remains elevated as compared to recent history.

Defensive Stock Market Internals – Inside Baseball

Stock prices have weakened slightly as the world’s economic and political uncertainties escalate. With the increase in volatility we’ve seen over the last nine months (both on the up and downside), how has the stock market reacted to these increased uncertainties?

The internals of the market tell us a lot about investor preferences and psychology. If investors are nervous, concerned about overall economic growth and consequently about economically sensitive earnings growth rates, they will tend to bid up prices of less-economically sensitive stock prices. Below is data showing returns of specific economic sectors over the last 12 months – a time when market movements became more erratic as concern about overall economic momentum started to wane. The defensive sectors are the business types we think will act in a more defensive manner in a downward market environment.

Defensive Sector Returns and Non-Defensive Sector Returns

It appears that investors have bought into the view that overall economic growth is slowing. They may have concern that rising business risks (uncertainty being reflected in capital spending plans due to tariff risks) has been moving investors’ preferences away from taking significant economic risks in portfolios (returns quoted are sector returns per Bloomberg). 

For reference purposes, the Standard & Poor’s 500 index generated a total return of 3.8 percent during the same period of time of the above measurements. With this in mind, four of the five defensive sectors have outperformed the overall market over the last year while only one non-defensive sector (consumer discretionary) outperformed the overall market over the last 12 months.

Reversion to the Mean Lends Credence to Owning Stocks 

A basic tenant of asset allocation concepts is that, over a long period of time, the variance on returns tends to move them back to a normal level. Or, returns tend to revert to a mean level. Below are 1-year returns of various asset classes over periods ending May 31, 2019.

1-year returns of various asset classes over periods ending May 31, 2019.

Notes from the above: 

  • Over the last four years, on a cumulative basis, global stocks have generated a strong positive return. That being said, the returns have been lumpy. They have been negative in two of the last four years.  
  • In the year ending May 2016, bonds outperformed stocks by 7 percent. The same story of bond outperformance occurred again over the last 12 months as stocks have generated a return of -2.7 percent, while bonds generated a return of 6.1 percent.
  • The sustainability of bonds outperforming stocks by such a wide margin, historically, has relied on the economy flowing into a recession and the Fed monetizing the banking system. We don’t see this happening over the next 12 months.

I Don’t Want to Chase Returns – Common Concern

So far this year, the S&P 500 has generated strong returns of 10.7 percent, which follows last year’s weaker-than-normal -4.4 percent showing. Now, virtually no investor wants to chase performance — fair enough.  High returns can be available within asset classes that are begging for capital. It is hard to say that U.S. stocks are begging for capital. During the last five years, the total return from the S&P 500 has been 58.5 percent, or an annualized return of 9.6 percent, which is pretty much in-line with long-term averages. 

But if we look at another market internal and dissect the S&P 500 return over the last five years, we find that information technology stocks have returned a whopping 119.4 percent, or 17.0 percent annual returns during that same period. Technology stocks now represent 20.7 percent of the S&P 500 capitalization, by far the largest economic sector weight of that broad index.

With that background, consider the following:

  • During the last five years, the top five names associated with tech were Apple, Microsoft, Alphabet (Google), Amazon and Facebook. These names over the last five years averaged about 11.5 percent of the weighting of the overall S&P 500 but made up about 25 percent of the overall S&P 500 return. 
  • Without this tech stock rally, the rough five-year average annual return for the S&P 500 would have been 7.3 percent per year, as compared to the actual return of 9.7 percent.
  • This analysis suggests that large cap U.S. stocks, excluding “hot” tech stocks, have generated a slightly lower-than-average annual return of 7.3 percent per year. This analysis helps negate the view that U.S. stocks, broadly, have run too far, too fast.
  • From a valuation standpoint, these five names are selling at an average P/E ratio 35.2x earnings, while the market overall is selling at 19.4x earnings (including the highly-valued tech segment). Without these five highly-valued tech stocks, the rest of the S&P 500 is selling at a multiple of 16.2x earnings (trailing).
  • According to Ned Davis Research (NDR), the S&P 500 has traded at an average of 19x trailing earnings during the last 35 years. It is hard to claim that the U.S. broad stock market is overvalued.  

Final Thoughts – Inside Baseball Tells Us to Remain Bullish

With the above, we are of the opinion that investors need to view the current market volatility with an opportunistic eye. Trade disputes, unsettlement in Europe, a deceleration in profit growth rates, uncertainty regarding the Fed’s monetary policy, and the upcoming presidential election are all weighing on investors’ minds. The increased level of pricing volatility in global equity markets may indeed continue.

As long as earnings growth remains positive and the economy stays out of recession, we retain our bullish bias.   

 

Source for performance data throughout the piece: Bloomberg 

This commentary is limited to the dissemination of general information pertaining to Mariner Wealth Advisor’s investment advisory services and general economic market conditions. The views expressed are for commentary purposes only and do not take into account any individual personal, financial, or tax considerations. As such, the information contained herein is not intended to be personal legal, investment or tax advice or a solicitation to buy or sell any security or engage in a particular investment strategy. Nothing herein should be relied upon as such, and there is no guarantee that any claims made will come to pass. 

The opinions and forecasts are based on information and sources of information deemed to be reliable, but Mariner Wealth Advisors does not warrant the accuracy of the information that this opinion and forecast is based upon.

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