Will Trump’s Trade War Derail the Markets?

Global equity markets had been bouncing back from early April’s lows as investors shifted their attention to the still relatively strong world growth outlook bolstered by favorable economic tailwinds such as the U.S. corporate tax cut and rising employment. However, the markets are now slumping and volatility is back again as new geopolitical risks emerge. Disruptive counterforces, including an escalating international trade war, political showdowns in Europe and currency devaluations in Latin America are beginning to work against the synchronized global growth scenario which appeared to be in intact earlier this year.

The major averages are up slightly on the year, but that masks considerable variance between regions and sectors. For example, the tech-heavy NASDAQ market is up 9.7% year-to-date, easily outperforming the broader S&P 500 stock index which has advanced by just 2.1% as of this writing. Meanwhile, Emerging Markets (EM’s) as a group are down 5.2% as measured by the MSCI Emerging Market index. Within the EM index, countries such as Brazil and Mexico have been hit much harder, falling 18.9% and 7.8% in U.S. dollar terms, respectively.

Volatility is back again this year as latent geopolitical tensions come to a head. The United States’ trade war with China and President Trump’s antagonistic approach to America’s most important trading partners has been a recent tipping point. Initially, Trump set his sights predominantly on China in an attempt to balance the scales of unfair trade practices and intellectual property infringement. But now, many of the U.S.’s closest allies are also being punished with tariffs and perhaps alienated altogether.

At the moment, the trade issue remains mostly unresolved, acting like the sword of Damocles hanging over the markets. Business leaders are reluctant to make longer term investments investment not knowing the new rules of the game.

For example, recent data show economic activity in the euro zone has been slowing down as fears of a trade war begin to take their toll. The Q1 economic slowdown in the euro region was caused by lower trade, coinciding with Trump’s threats in March of high duties on steel and aluminum imports from global partners, including the EU. These threats turned into actual tariffs earlier this month.

The euro zone’s output expanded by 0.4 percent during the first three months of the year, down from the 0.7 percent growth of the previous quarter. For the year as a whole, growth slowed to 2.5 percent from 2.8 percent. Germany, the euro bloc’s largest economy and main exporter, saw the growth of its output halved to 0.3 percent during the period. German automaker Daimler AG, producer of Mercedes Benz vehicles, issued a profit warning last week due largely to China’s retaliatory tariffs on U.S. car imports against its overseas operations.

While tariffs clearly played a role in slowing activity, Europe also has issues of its own making. The ultimate resolution of 2016’s Brexit vote in the UK remains a work in progress and recent political turmoil in Italy and Spain are creating more problems and concerns for the 19-country currency block.

Meanwhile, EM’s have been rocked by rising U.S. interest rates and the rebounding greenback which have sent some EM currencies into a tailspin. Upcoming elections in Mexico are a concern where a potentially disruptive left-wing candidate is leading in the polls. Brazil also appears once again fragile as a new corruption scandal and recent truckers’ strike hamper any potential economic gains from higher commodities prices.

On the positive side, there may be hope for a resolution on trade. Many of Trump’s prior initiatives have been walked back considerably before becoming policy. Clearly, he desires better trade deals for the good of the American people, but the complexity of the global supply chain make those decisions very difficult to implement without creating substantial offsets. If tariffs remain in place and become more onerous, rising consumer prices and retaliatory measures will hurt everyone. Elected officials will eventually need to heed this call. Already, industry leaders are complaining about the new tariffs and asking for exemptions.

Despite the rising tide of geopolitical uncertainty, valuations are arguably already reflecting more dire outcomes. Despite the political dysfunction in Washington, the U.S. remains the “go to” place for global funds as the greenback rallies on the back of Federal Reservice interest rate increases. Moreover, the S&P 500 stock index is trading at about 17X forward earnings, not unusually demanding by historical standards, particularly when considered in within the context of the still historically low interest rate environment. Moreover, analysts expect S&P 500 corporate profits to advance by almost twenty percent this year and see growth of a further ten percent in 2019. Corporate earnings are the ultimate driver of stock prices.

In the short run, U.S. small cap stocks, especially those falling into the ‘value’ category look like a good bet for relative forward progress. Smaller companies generally possess higher domestic footprints, meaning they are less exposed to the negative economic revisions and more volatile financial conditions in the EM’s and Europe. Furthermore, the U.S. tax cut directly benefits the bottom line of these companies to a greater extent than the larger, multinationals which have already been paying at a lower tax rate.

Geopolitical disruption has fallen heaviest on the EM markets and select positions are beginning to look enticing on a longer-term basis. In fact, EM’s as a group are trading at just 12.1X forward earnings which represents a discount of almost 30 percent to the S&P 500. The EM markets are perhaps more sensitive to evolving geopolitical events, but investors with patience have more to gain when the dust settles.

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