The last time Washington and Beijing locked horns, global equities sold off by around 20 per cent. This time, markets have shrugged off the blustery tweets, responding to escalation threats with somewhat bizarre aplomb.
The 10 per cent tariff currently being charged on $200bn (£158.6bn) of goods entering the US has been increased to 25 per cent. The remaining $300bn (£237.9bn) or so of goods that China imports to the US may also face tariffs.
Why are markets seemingly irrationally sanguine? In part, it may be seen as rhetorical sabre rattling. More likely, the market is taking solace in the fact that the US central bank – the Federal Reserve – is showing willingness this time around to pick up the pieces and support the economy.
Fed rhetoric has now completely changed. If ‘restrictive’ was the buzzword in the corridors of the Fed in September, it is now ‘patience’. The market has shifted from expecting two further rate hikes this year to rate cuts. Moreover, the Fed has put off its plans to run down the balance sheet. Large levels of liquidity in the financial system are here to stay.
The key question is: can the monetary authorities really counter the potential economic fallout from a hostile political agenda? The answer is: at this stage of the economic cycle – no. The US is at, or very close to, full employment. The unemployment rate is 3.6 per cent, the lowest it has been for almost 50 years. There is no more easy growth to come by. Companies cannot easily pull in a few more staff to meet a new order.
At this point in the cycle, further economic expansion gets trickier. Firms need to invest. They need to equip their current staff with better tools and technology to squeeze a bit more out of them.
But it often takes a bit more conviction on the part of firms to increase investment than it does to increase staff, particularly in these days of zero-hours-worker contracts. The commitment to expand a plant or buy machinery is often more costly and irreversible.
Given tremendous geopolitical uncertainty, companies will not have that conviction. During the last round of disagreement between Washington and Beijing, US capex intentions plummeted, according to the Duke CFO survey.
Without a capex and sustainable productivity revival, the US will not be able to sustain growth of much more than 1.75 per cent, given that working-age population growth is now roughly 0.5 per cent. This would represent a marked slowdown from the 3 per cent and more the US has experienced for much of the past 18 months.
We have to stop believing that our central banks can generate lasting growth. Central banks merely steal growth – either from the future by tempting people to spend and borrow today at the expense of the future; or from other parts of the world, by forcing down exchange rates and grabbing a bit of growth from the neighbours.
They manipulate demand. They do not, in the main, generate supply-side capacity. Supply-side expansion sits more squarely in the realm of government policy – via migration policy, most directly, or more subtly via education, property rights and other economic policies which attract global business.
Put simply, if the Fed keeps pumping demand while the political risk deters investment, the end result will be unbearable pressure on the labour market and further upward pressure on wages. US corporate profit margins – a massive contributor to the growth in US earnings – will come under pressure.
There are three significant investment implications:
First, earnings expectations for the S&P next year at 11 per cent look too high. Given current valuations, any downward revision to earnings expectations will restrict gains in the US stock market. As such, a more regionally diversified portfolio makes more sense than being heavily skewed to the US.
Second, US growth stocks – which have been the bedrock of US outperformance – might not command such eye-catching multiples in a world in which growth is more modest. The premium currently assigned to growth stocks over value stocks is likely to narrow.
Third, leverage has expanded greatly in the US corporate sector, taking advantage of the low borrowing costs offered in both public and private markets. If growth slows, the burden of this debt will feel more onerous. This suggests a focus on quality stocks, which in our view are companies that have good free cashflow and strong balance sheets.
Karen Ward is chief market strategist for EMEA at J.P. Morgan Asset Management