Market sentiment turned decidedly sour in May as a result of an unexpected worsening of trade negotiations between the US and China. Global equity markets around the world sold off in the high single digits; China’s stock market seeing the worst drawdown. As part of a move to safe haven assets, the yen and dollar strongly outperformed but the most eye-catching move was in the bond markets where yields moved significantly lower and German 10-year bunds entered negative territory.
At the beginning of the month Trump threatened to increase tariffs from 10% to 25% on £200bn Chinese exports into the US and promptly made good on his threat on 10th of May. So how damaging do we think the new tariffs could be for the US and China’s economies? Looking at the current context in the US, conditions are such that the US is well poised for a recession, needing only the catalyst. The labour market is tight, and companies are having to invest and hire in order to protect their market shares. Preceding every recession since the 1970s there has been a demand shock caused by sharp increases in energy costs. With the oil price depressed, could tariffs indeed cause the next recession?
At this stage, we think that is unlikely. Firstly, Chinese imports into the US account for just 1% of total consumption and we estimate tariffs would need to rise to 88% from the current 25% to cause an equivalent oil price shock of the scale associated with onset of recession. For now, consumer demand is supported by lower bond yields and oil and confidence that is close to a 50-year high.
But what is the impact on China given the new tariffs apply to more than half of all their exports to America? China’s exports to the US account for just 3.4% of GDP and the government is likely to offset the impact with further stimulus as it did so at the beginning of the year. With the 70th anniversary of the People’s Republic in October, the government will need to prove its effectiveness. While we are closely monitoring the situation, we don’t think now is the time to de-risk any further.
Closer to home, UK politicians failed to resolve Brexit and the Prime Minister opened the leadership challenge in the conservative party by announcing she would step down in June. The search for her replacement is underway and a general election seems inevitable given the current Parliament has been unable to deliver Brexit. The European Elections saw the Brexit Party get the most votes making a no-deal scenario more likely. We don’t think UK equities look attractive considering continued uncertainty.
Anna Haugaard, CFA
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