In the lead up to 2016’s Presidential election, then nominee Donald Trump made a series of promises to create MAGA – ‘make America great again’. The pledges to achieve this included significant tax reforms and a return to nationalism. Despite fears of a market downturn upon his election, the US markets have subsequently reached several new milestone highs.
Nearly two years into the new presidency, Trump has honoured these promises. The changes to the tax code introduced a year ago saw a surge in corporate earnings and share buybacks, which in turn contributed to the extraordinary growth in price to earnings (PE) ratios.
Trump not only withdrew the US from significant trade pacts, he introduced a range of tariffs on products from many countries, notably China. This has sparked a tit for tat trade war, the potential ramifications of which are now being reflected in global sharemarkets.
Divergence in global markets
During the quarter ending 30 September 2018, there was a significant divergence between the performance of the US stockmarket compared to emerging markets and Europe. Trump’s hard stance on tariffs and his trade wars have driven fear into emerging markets especially China.
This created a stark divergence in the performance of equity markets as illustrated in figure one; the US market continued to rise, driven by the concentration of the market in large capitalisation technology stocks such as Apple and Amazon, where incessant inflows pushed up valuations.
Figure one: Divergence – S&P500 versus FTSE All World
However, October lived up to its reputation of being a tricky month for the sharemarket. By 24 October, the S&P500 had fallen 3.1%, posting its first one-year negative return in quite some time. At the same time, the volatility index (VIX) – which has been unusually subdued – spiked up.
In Europe, weakening manufacturing numbers, a populist five Star movement-legal coalition in Italy and problematic Brexit negotiations have raised cause for concern. Further, falling automotive sales have also driven worries about a global macroeconomic slowdown.
In emerging markets and Europe, outflows are driving markets lower and with them, valuations. Despite this, there has not been much of a change in the fundamentals and earnings in these regions and respective industry sectors.
In the short term, stock prices simply reflect sentiment as the sharemarket is a voting machine, rather than a true reflection of fundamental value for the asset you are buying. Valuations in each geography are moving in different directions, which presents opportunities that weren’t available at the start of 2018.
Tariffs and trade wars
You would be forgiven for thinking China and emerging markets are entering a recession by the way share prices have reacted in the past three months. However, the IMF only downgraded its forecast for Chinese gross domestic product (GDP) growth in 2019 by 20 basis points to 6.2%.
While the trade tariffs are expected to impact Chinese GDP growth by 1.5%, domestic policy stimulus is expected to offset a large part of this impact. If you think about the tariff impact, Chinese exports represent 18% of GDP and China’s exports to the US represent 19% of this figure. So while the impact is not trivial, it is manageable.
China’s exports accelerated from 9.8% YoY growth in August to 14.5% growth in September. The Yuan has depreciated by 11% since March against the US dollar. This is not insignificant and enables Chinese exporters to offset some of the impact of the trade tariffs. President Xi Jinping and the Chinese government are using the currency as part of this trade war. It is no surprise that Steven Mnuchin, the US treasury secretary, has recently stated “We are going to absolutely want to make sure that as part of any trade understanding we come to that currency has to be part of that.”
Interestingly, US GDP growth is expected to decelerate from 2.9% this year to 2.5% in 2019. Tariffs actually cause inflation and with US unemployment at 3.8%, the Federal Reserve will need to increase interest rates and remove liquidity from the system.
US v China
I recently attended an Alibaba investor day in Hangzhou where Jack Ma gave a speech about why he was stepping down as Chairman. He said that the US has a history of going after an emerging superpower and did the same thing when Japan became the second largest economy in the world in the late 1970s. China surpassed the size of Japan’s economy in 2010 and will rival the US over the next few decades. Jack Ma believes that this trade conflict may continue for the next twenty years.
Xi Jinping wants to ‘make China great again’. He has stated that by 2025 he wants China to dominate its domestic markets in 10 major new technologies including driverless cars, artificial intelligence and quantum computing. In 2035, he wants China to be the dominant force in technology and innovation everywhere.
Donald Trump is accusing China of stealing intellectual property and this is part of the basis for the trade war. The US does not want to cede its dominant position to China, while China wants to keep growing and ‘make China greater’. These two ambitions might not be mutually exclusive if the Chinese and US can come to an agreement. However this is unlikely to occur prior to the mid-term elections.
While the US still comprises 55% of the MSCI World Index, it actually only represents 23% of global GDP and this share is shrinking over time according to forecasts provided by the IMF. At Perpetual, we aim to invest in tomorrow’s leaders at attractive prices; as fundamentally driven investors, we look to take advantage of market fear to buy into quality, growing businesses at value prices. We believe the environment today will provide us with good entry points over the course of the next year.