The trade war between the United States and its trading partners (mainly China and the European Union) has escalated in recent weeks and has been dominating headlines around the world. It has also caused increased volatility in global markets as investors try to digest the effect of the tariffs announced by the various role players on company valuations. In our commentary at the end of this month’s newsletter, we will take a closer look at how this has unfolded so far and what it could mean for investors.
Most economic indicators show that the global economy is still in an expansionary stage and talks about a looming recession, especially in the United States, may be premature. Employment in the United States, Europe, Japan and the United Kingdom continues to accelerate with the US and UK nearing full employment. Interestingly enough, wage inflation has not yet started to raise its head, the upside risk is steadily on the increase. While headline inflation is at or near targeted levels in most advanced economies, it is likely to quicken across the emerging market spectrum due to the recent bout of currency depreciation, especially against the US dollar.
The US Federal Reserve is likely to prioritise changes in the US real economy over global events when it decides on the future path of interest rates. A sustained recovery in economic growth, paired with mounting underlying price pressures, stand in support of additional tightening following the increase of 0.25% (to 2%) in their Federal Funds Target Rate on 13 June. In Europe, recent comments by prominent members of the European Central Bank’s Governing Council, suggest that the ECB will unwind its asset purchase programme by the end of this year, irrespective of the situation in Italy. Seemingly dovish Bank of England officials are also changing their stance by signalling a possible interest rate hike in August. In developed markets, monetary policy is therefore likely to tighten in months to come.
Overall, the global economy seems healthy and is likely to support the strong company earnings growth that we’ve seen since the global financial crisis.
Following the recent bout of “Ramaphoria”, local investors have realised that all is not as rosy as it was made out to be following the change in the ANC’s and country’s leadership a few months ago. From a South African economic point of view, recent data releases have been sobering. PMIs, retail sales, mining and manufacturing production have all disappointed, posing further downward risk to economic growth following the contraction of 2.2% in the first quarter of 2018.
The likely path of monetary tightening by major central banks (as mentioned above) and the slowing global economic growth could lead to further declines in appetite for emerging market debt (including South Africa’s government and corporate debt) and further selling. During June, foreigners sold R33.7 billion worth of South African bonds, which partially explains the recent weakness in the rand against a range of foreign developed market currencies. However, while foreign investors have, overall, increased their holdings of South African bonds over the last few years (to now hold nearly 40% of South Africa’s rand denominated government bonds), domestic investors’ (mainly pension funds) holdings have declined materially. Therefore, further foreign selling is likely to be absorbed relatively easily by South African institutions considering that at current levels, bonds are offering attractive inflation adjusted yields and are better priced compared to other asset classes than they have been for some time.
The planned implementation of National Health Insurance (NHI), delays in discussing the mining charter and talks around expropriation of land without compensation are not exactly filling foreigners with confidence and as such, much needed foreign direct investment has been much slower than anticipated by the Ramaphosa administration.
It’s not all bad news though. The current administration is slowly but surely changing the boards and management structures of state-owned enterprises, and coupled with increased policy certainty it could set the foundation for improved economic growth over the next decade.
Emerging markets were once again on the wrong side of the risk off trade in June. As the US Federal Reserve tightened liquidity, the strengthening US dollar saw emerging market bonds and currencies underperform. This underperformance was further intensified by fears surrounding how possible trade wars would affect global growth (especially growth in emerging economies). South African equities were leading the performance tables thanks to the large, rand-hedged counters. These stocks followed the trend in developed markets and performed well in June, with resource stocks once again the top performers for the month.
Alongside its emerging market counterparts, the Rand continued to deteriorate during June and gave up around 8% against the US Dollar, Pound Sterling, and the Euro.
Mid- and small cap shares continued to underperform large caps and are now almost 15% behind over the last 12 months. Over 10 years, these shares have still outperformed those with larger market capitalisation, but they have consistently struggled in a very benign local growth environment.
South African property securities ended the six months from the start of the year more than a fifth lower following the Resilient debacle in January. As an asset class, it looks more attractive at these levels, but investors should be circumspect before betting the house on a short and sharp recovery.
Commentary: United States and trade wars
A long-threatened trade war between the US and China has got underway early in July after the world’s two largest economies imposed tariffs on each other. The Trump administration implemented tariffs on US dollar 34 billion in Chinese goods, to which Beijing responded with levies on a similar quantity of imports from the United States.
Ahead of the tariffs, Chinese state media published a series of editorials criticising the US and emphasising the country’s readiness for a trade war. Chinese companies and investors girded for the worst, while economists cautioned any impact on the economy would be minimal. China’s central banker said Trump’s promised tariffs of 25% on USD 50 billion of Chinese goods – the initial USD 34 billion to be followed by USD 16 billion in a few weeks – would shave 0.2 percentage points off China’s GDP and the “overall impact would be limited”, according to their central bank.
This follows the early salvos in the potential trade war between the Yanks and their European trading partners as Donald Trump threatened the European Union with a proposed tariff of 20% of all cars manufactured in Europe and exported to the US. As a possible retaliatory measure, the European administration in Brussels had started work on identifying a list of about EUR 10 billion in US imports to target if Mr Trump carries through with his threat. The implementation of the Trump tariffs was widely expected given his promise to protect jobs in the United States at the expense of a wide variety of global firms.
It also has the unintended consequence of various US firms announcing that they are moving their manufacturing outside of the United States in order to avoid EU tariffs on goods exported to member countries. Harley Davidson, for instance, announced on 26 June that its plants in India, Brazil, and Thailand would ramp up production in order for them to avoid EU tariffs of as much as USD 100 million. It could be that the inimitable Mr Trump’s moves will create a backlash that he just did not see coming.
These were not the first tariffs though – in January 2018, Trump imposed tariffs on solar panels and washing machines, and later the same year, he imposed tariffs on steel and aluminium. On the 1st of June 2018, the US imposed a 25% tariff on imports of steel and a 10% tariff on aluminium, on the European Union, Canada, and Mexico.
All this talk of trade wars has made headlines around the world and has many investors worrying about the effect that this would have on global markets. It’s therefore very important to put it into perspective. According to Deutsche Bank, most investment analysts agree that the trade war is so far not having any meaningful impact on the US economic outlook. Specifically, tariffs on USD 34 billion of imports is very limited when taking into account that US total imports are around USD 2.5 trillion per annum. If we begin to see tariffs on motor cars or auto parts, then it will be much more serious because US auto manufacturers, suppliers, and dealers account for around 7% of total employment in the US economy. The bottom line is that the negative impact of the ongoing trade war is small, but if the trade war moves to cars and car parts, then it would begin to exert a meaningful drag on US economic growth and hence also on equities and interest rates.
In summary – at the moment the Trump Tariffs represent more of a scuffle than a battle or a proper trade war. It’s early days though, so we’ll watch these developments very closely. At the very least, cartoonists are benefiting from