Stock markets around the world started to price in the optimism of a phase one trade deal in early November, seeing record highs as we approached the traditional ‘Santa rally’ of December.
That was until the optimistic consensus was rattled, when Trump suggested there could be no trade deal with China until after the 2020 US election, and ordered a round of tariffs against Argentina, France, and Brazil.
The S&P 500 suffered its biggest daily loss in almost two months, after printing a series of record highs since early October.
Markets had come to expect that Washington and Beijing would ink a phase one deal that would postpone the next round of tariff talks, scheduled for 15 December, until January. This round of tariffs is set to cover almost all remaining Chinese exports, covering a broader selection of household and consumer products including cell phones and laptops.
So, what happens if the 15% tariffs on $160b of goods are, unexpectedly, enforced?
Trump the Tariff Man
It’s been a year since Trump infamously tweeted ‘I am a tariff man,’ and it’s clear he still is, claiming he’s in no rush to repeal tariffs if trade negotiations don’t go his way.
A year on, let’s look at the data to see how the Tariff Man’s mission to ‘make America rich again’ has shaped up.
Starting at the surface, the US stock market has soared in the last year. See below the daily chart for the S&P 500 (US500). The index has risen from 2707 to 3115 in one year. That’s a tidy 15% return.
And Trump wants to make sure we know it. Below is one of many tweets celebrating the S&P 500 closing at yet another record high.
Caption: Tweet from @realDonaldTrump: Another new Stock Market Record. Enjoy!
The stock market moves hard and fast, with quick reactions to headlines, good and bad. Under the hood, things aren’t as rosy.
The bond markets give a different image. While a record high stock market suggests a risk-on mood (bolstered by liquidity from the Fed’s expanding balance sheet), the 10-year US bond yield suggests a relatively risk-off mood. Yield sits this morning at 1.77% - that’s only 32bp (basis points) from the all-time low 1.35% in August 2016. On 4 December 2018, when Trump declared himself the ‘Tariff Man,’ the 10-yr yield was 2.91%.
Typically, yields reflect confidence in economic activity: high yields = high confidence and low yields = low confidence. It’s a check-up on the overall health of the economy, although, not just in the US, but the term premium is driven by global factors. While the stock market has soared, bond yields have fallen considerably. This indicates an underlying pessimistic mood, driven closely by dovish global centrals and partly in reaction to the tariffs imposed through the US-China trade war and faltering economics. You can read about the close relationship between USDCNH and 10-year yields in my piece Trade-driven treasuries.
Caption: The US 10-year treasury yield has fallen from 2.91% to 1.77% in the past year, hitting a year-low of 1.45% on September 3rd.
Also seemingly contradicting a soaring stock market are our key US economic indicators, which have depreciated alongside bond yields (white). ISM manufacturing (blue) has fallen from 54.3 to 48.1. Above 50 indicates expansion and below 50 contraction: sliding into contraction reflects poorly on the trade war. Then consider US nonfarm payroll data (green), and we see fewer and fewer jobs created month-on-month, although keep in mind that US unemployment is near a 50-year low, which could be restricting room for growth here.
10-year yields (white), ISM manufacturing (blue), and nonfarm payrolls (green), have tracked down in the past year.
The US Agriculture Department has distributed more than $15bn USD in tariff relief payments to farmers and ranchers since the trade war began. The trade war and its tariffs are dragging on the US economy, and if no Phase One deal eventuates next week, the outlook looks even worse. If tariffs go in, clearly China are not going to buying north of $50b pm in ag products.
Market Scenarios on Tariff Implementation
December is typically a good month for stock markets, but tariffs kicking in could be the nightmare before Christmas that stops the ‘Santa rally’ in its tracks.
A phase one deal seemed inevitable leading into November, and stock markets rode the wave of optimism to record highs, backed by a massive expansion of the Fed’s balance sheet. But the bond market was more cautious, likely awaiting a tangible deal before getting too excited.
The optimism first faltered when inking the deal in Chile was delayed due to the cancelled APEC meeting, but Beijing and Washington assured the markets a deal was in the works. Then earlier this week Trump hinted he could hold off a trade deal until after the 2020 election, the S&P dropping 0.85% on the day’s trading. Despite spooking markets, the president maintains that trade talks are going ‘very well.’ Markets have heard this time and time again.
If the tariffs do kick in, we’d likely see a considerable market adjustment, with a strong tightening of financial conditions, as markets were optimistically pricing in a phase one deal for some time, or at least an extension of the current arrangement.
For example, USD/CNH, our default trade proxy currency pair, cooled a bit early November when a phase-one deal seemed more likely. In the case of the no deal and tariffs enforced, we would see the off-shore Chinese yuan CNH weaken against the greenback. AUD and NZD would fall with CNH.
EUR/USD would see a bid up, with the USD falling sharply against the JPY and CHF. Gold would fly, and we could easily see the yellow metal back above $1500 per ounce.
If we saw tariff rollbacks, a highly unlikely scenario, it would be a very Merry Christmas to all and stocks would fly.
So, if scheduled tariffs do kick in, the outlook blurs. We’ll return to looming prospects of a US recession and heightened uncertainty as markets become risk-off. The grinch may not steal Christmas this year… but the Tariff Man might.