After President Trump's trade-war tweet on May 5 and the market's subsequent fall, the S&P 500 has rallied about 3% from the lows of 2805, although it is still off its all-time high of 2950.
It seems investors and traders are stubbornly holding onto hope that a U.S.-China deal will be signed soon. However, considering the angry tweets and nationalistic chants exchanged between the two countries, it is close to impossible to expect any imminent amicable solution.
How can we when either side will not want to appear weak and giving in? After all, the markets have only fallen 3-5% so a lot of financial muscle needs to be flexed before either side shows some semblance of humility to negotiate.
I believe China actually wants to come to a mutually beneficial agreement that could even out the trade balance a bit, the main reason for the trade talks to begin with. However, Trump, on his high horse, only wants one thing, in my view: China to meet all his demands.
Why would China do that in their right mind? As a result, there is no common ground to meet, for the time being.
It seems the market has not learned its lesson. This seems like a page right out of the 2018 playbook as Trump last week banned American companies from selling to Huawei, without getting approval.
The market did not shrug as random one-liner tweets from Treasury Secretary Mnuchin and other U.S. officials stating "serious talks are taking place" kept the buyers ready. It's an interesting tactic to have serious negotiations while squeezing the other side's national assets while trying to reach a compromise.
Alphabet (GOOG) L just announced that it will cut off Huawei's mobile access to most of its Android operating systems, whilst Intel (INTC) , Qualcomm (QCOM) , and Xilinx (XLNX) have said they will stop selling chips to them. If this is not an escalation of an outright trade war, then what is?
Huawei bonds got hammered last week following through on Monday, which could intensify worries about the company. The VanEck Vectors Semiconductor ETF (SMH) has been trending lower since the start of May, not benefiting from any rallies as this sector faces serious pricing issues as is. This ban will only make matters worse. Let's not forget the sector rallied 45% since January lows; it is only about 15% off the highs.
The market is confronting the possibility of two types of crises: a dollar crisis and a Chinese debt crisis. Most have posited on the latter being the ultimate doom and gloom for the markets for years. Be that as it may, it is very hard to predict when that ticking bomb will go off.
As for the dollar crisis, we are already in the middle of one developing. The dollar has been rallying against a basket of currencies including emerging market ones, with the Turkish lira and Chinese yuan being the most disturbing. This highlights a major risk for countries with dollar debt as their servicing costs go up.
As Trump raised the tariffs on Chinese imported goods to 25% from 10%, low and behold, the yuan started dropping in the background. It was trading around 6.65 yuan to the dollar for most of this year, until recently falling to 6.94 to the dollar, threatening the all-important 7 level.
However, to Trump's detriment, with his labelling China a currency manipulator, he may be getting a bit more than he bargained for. With the increase in tariffs, and by letting their local currency fall, China's cost of export is lower, which can offset some of the cost increases for the local exporters, sort of a zero-sum game for them. According to a Deutsche Bank note, the latest increase in tariffs to 25% on $200 billion of goods is consistent with USD/CNY close to 7.10. If Trump went ahead with 25% tariffs on the additional $300 billion of goods, this could easily take the currency to 7.4 or lower.
Suffice it to say, this war is not over. Unless the global economy falls off a cliff and markets collapse 15-20%, I am not entirely sure either side will give in. But then Trump has a 2020 deadline and China can afford to wait to see if the Democrats get their act together. Perhaps Fed Chair Powell will be forced to come in and save the day lowering rates, which is what Trump wanted all along!
This could be a "beautiful" plan, but Trump has also decided to raise the ante on condemning Iran and sending aircraft carriers to the region. The Iran situation will only keep oil prices stubbornly high, especially going into the peak summer driving season where gasoline demand picks up. Without realizing it, as oil prices stay higher, core consumer price inflation will be sticky. Combined with lower global growth, this is one toxic recipe for stagflation!
Stagflation is bearish for risk assets and cyclicals, especially equities as an asset class. Trump might get his market sell-down but one begs to ask what can or will the Fed do if growth is so weak that markets collapse but their all too favorite CPI stays high and rises? Checkmate for the Fed and even worse for the equity markets.
Despite outflows seen over the last two weeks, it seems most retail investors are still long and adding as they stick with the "buy the dip mentality" without questioning whether any change in the cycle is possible. Perhaps "we" (humans) are the machines after all?