Equity markets and risky assets are suffering on a global basis as a result.
After we are done fretting about the near-term impact, the real question for long-term investors is what to do after the markets have corrected some.
Before we answer that question, we need to get a few inconvenient truths out of the way:
- The net impact on the global economy is clearly negative, even in the short run. If all tariffs get imposed, that is a fiscal consolidation of roughly $100 billion for the U.S. economy. If the status quo persists, factoring in the positive impact of the U.S. budgetary expansion of a few years ago, the tariff-related fiscal consolidation will probably shave off roughly 0.5 % of U.S. GDP growth. As a result, instead of growing at slightly above 2% for the year, the U.S. economy probably grows at slightly below 2%. From a fiscal consolidation and financial condition standpoint, the impact of the tariffs actually would be much less than the impact of the strengthening of the dollar in 2014-2016.
- Similarly, if the status quo persists and China doesn’t devalue its currency, the net impact of tariffs on the Chinese economy is probably slightly more than 100 basis points, lowering Chinese growth to slightly less than 6%.
- If China devalues its currency in response, it will make the tariff-related pain a global problem, the impact on Chinese growth will be slightly less, and its economic growth probably stays above 6%. However, growth in other countries will be slower, and the net impact on the global economy probably remains in the same ball park.
- From a longer-term perspective, the impact of a Chinese currency devaluation is that global capital spending plans are probably reduced and global growth will remain challenged for a while longer.
Considering that I, and the rest of the market for that matter, was expecting a more amiable solution to the U.S.-China trade dispute, a derating of global equities is to be expected. The global markets have been delivering that verdict since last week, and there is probably some more pain to come.
Looking Long Term
But what about the long term after the derating?
I think the right trade and tariffs model for long-term investors is Brexit. Given the political environment in the U.S. with a presidential election upcoming in 2020, it is prudent now to assume that this issue will be with us for quite some time. While there may be a lot of back and forth, and partial solutions may be achieved at times, a final, comprehensive resolution is likely to be years in the making. On the other hand, if the U.S. and China surprise us with a quick resolution, that would be a bonus for global growth.
In that context, it might be worthwhile, considering how global policymakers are likely to react to the slowing economy. My expectation is, if the downward growth trajectory accelerates, the likelihood increases that the U.S. Federal Reserve (Fed) responds with a rate cut.
Similarly, Chinese policy makers, who have been quietly but definitively stimulating their economy, are likely to respond with more fiscal stimulus.
It would not be unrealistic to expect other policy makers to do the same.
Global Growth Likely to Slow
Under that scenario, I expect global growth will slow from its current pace of recovery, but the slowdown is unlikely to be catastrophic. And I continue to believe that the U.S. expansion probably lasts a while longer than what most market participants are expecting.
With the prospects for a recession still relatively modest, from an asset price perspective, the current 10-year bull market has been built on two key foundations: Easy monetary policy on a global basis led by the Fed; and China’s fiscal stimulus preventing the Chinese economy from slowing down.
If anything, the trade war forces policymakers on both sides to reinforce those foundations.
As a result, I expect the current turmoil to be another market fracas in a long series of mishaps that we have encountered in the current cycle.
It is still a secular bull market that is consolidating rather than giving up the ghost. Having said that, it would be imprudent to assert that risks have not increased. The slowdown in growth is real and unwelcome.
However, in my opinion, we have market metrics to monitor that will tell us whether the investing environment is becoming untenable.
The dollar remains my ultimate weathervane, and in my view, the outlook for the dollar is stable to weaker, given:
- Equalization of global growth, with the U.S. growth spurt slowing;
- U.S. monetary policy remaining easy for an extended period; and
- U.S. growth being helped by easy money, while Chinese growth is supported by fiscal stimulus.
For now, that is how I see things playing out. If that changes, it will represent a reversal of flows for safer havens and it would be time to revisit the positive story.
Keep an Eye on Credit Spreads
Credit spreads are the other barometer to watch. In this expansion, if there is a pocket of concern, it is corporate credit growth, which has been meaningfully higher than nominal global GDP growth. If credit spreads widen meaningfully, the ensuing tighter financial conditions may end up being catastrophic for the corporate sector and the global investment outlook.
In the current cycle, the closest we came to the end of the cycle was in 2015-2016, and both of those metrics were flashing red. Today, that certainly is not the case.
The bottom line for long-term investors, then, is to stay invested in global equities, with a careful eye on the dollar and credit spreads.
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