SINGAPORE (July 16): The escalating, multi-front trade war between the US and major economies, particularly China, is casting a shadow on the global economic growth outlook. Coupled with rising interest rates and growing concerns that the longest US bull market in history might be on its last legs, investors could be starting to worry. In Singapore, the Straits Times Index has erased the gains it made earlier this year, falling back below the 3,300 mark.
Yet, despite these concerns, A J Kahling, senior manager of trader education and market strategy at brokerage firm TD Ameritrade, is urging people to stay invested. Everyone should “take deep breaths and consider all aspects of the market”, he says at The Edge Singapore’s 2018 mid-year investment forum on July 7. Kahling was one of four speakers invited to share their views on the mid-year outlook.
Nevertheless, investors need to keep close tabs on further developments on the trade front. Action might just follow rhetoric; with much pride at stake, both the US and China are unlikely to back down easily. Trade tensions might just ratchet up, with more retaliatory measures lobbed by either side on a wider mix of products, says Kahling.
On July 6, the US started levying a 25% tariff on US$34 billion ($46.3 billion) worth of Chinese imports. China has hit back with a 25% tariff on major US imports, including soybean, also worth US$34 billion.
The first volleys caused little reaction in the market, and Kahling notes that it was likely that the round of tariffs had been priced into market expectations. Strong US jobs numbers, released on the day the tariffs kicked in, helped divert attention as well. Indeed, the major US indices — the Standard & Poor’s 500, Dow Jones Industrial Average and Nasdaq Composite Index — closed higher at 0.8%, 0.4% and 1.3% respectively. Similarly, in China, the Shanghai Composite Index ended 0.5% higher. In Hong Kong, the Hang Seng Index close 0.5% higher.
On July 10, however, US President Donald Trump reportedly kicked off the process of slapping a 10% tariff on a further US$200 billion worth of Chinese products. This latest escalation by Trump caused markets around the world to drop. Market experts and economists fear further escalations. Speaking at the July 7 forum, Kahling points out that the quantum of affected trade, while significant, needs to be seen in the context of the size of the US and China’s economies, worth US$20 trillion and US$12 trillion respectively.
So far, the US tariffs now in place have hit Chinese solar panels, washing machines, steel and aluminium. Chinese telecommunications equipment maker ZTE Corp seems to have been caught in the crossfire early on. It was accused of defying a US export ban of equipment to Iran and North Korea. The Hong Kong-listed company settled the charges by paying the US a fine of about US$2 billion.
Meanwhile, China has slapped tariffs on 128 American products, including wine, meat and pipes. China’s exports to the US outweigh imports by four to one, however, which means there is a limit to how hard China can hit back via tariffs on US goods. This means Beijing may instead retaliate in other arenas, such as action against US firms operating in China. China could also place perishable US imports under quarantine, whether necessary or not, as it had reportedly done so for a US company that exports cherries, says Kahling.
Another target could be tourism: Chinese tourists spent US$18 billion a year in the US and it may well restrict the travel of its citizens to the US, as it had done previously for other markets such as South Korea.
By most accounts, the US economy has been strengthening. Improving employment and GDP growth numbers have given the US Federal Reserve reason to normalise interest rates, a decade after the global financial crisis. On June 13, the Fed raised its benchmark interest rate for the second time this year, by 0.25%, to 2%. The central bank has also guided for two more hikes before the year is up.
US markets are looking forward to the second quarter of earnings that have benefited from Trump’s tax cuts on corporates, from 35% to 21%. Earnings growth in 2H2018 is expected to average at 19%, according to some estimates. This is led by the energy sector, followed by the materials and tech sectors. Naysayers scoffing at the artificial lift to earnings from lower taxes might want to look at overall revenue growth of 8.7%. “The US equity market is still chugging along, showing resilience,” says Kahling. These fundamentals aside, it looks as if the current market up-cycle — one of the longest on record — risks waning soon. Specifically, the US Treasury yield curve is starting to flatten, which typically signals a recession on the horizon, says Kahling.
Essentially, the yield curve is the difference between interest rates on the short-term two year US Treasury bonds and the longer-term 10-year notes. When an economy is buzzing, the rate of long-term bonds tends to be higher, to compensate for price-induced inflation down the road. Now, with the Fed raising short-term rates, the gap between the short- and long-term interest rates is narrowing. In late June, the gap between two- and 10-year US Treasury bonds was 0.34 percentage points — a level last reached in 2007, just months before markets collapsed.
Kahling notes that since the 1970s, there have been five occasions on which a recession occurred after the yield curve became inverted; on average, the recessions that eventually happen started about 17 months after that mark. He reckons that the Fed’s hawkish stance could now trigger an inversion in the yield curve. He notes that the market expects the Fed to hike rates to as high as 2.5% this year.
This, in turn, is likely to influence other short-term interest rates, such as the US twoyear Treasury bills, and lead to a yield-curve inversion. “If this trajectory continues, it will increase [the yield] of two-year Treasury bills. The 10-year Treasury bills are not as sensitive to this interest rate [hike],” Kahling explains.
He acknowledges that history might not repeat itself, though investors cannot ignore such observations. “It doesn’t tell me to run for the hills right now,” he says. “It hasn’t inverted yet. We don’t know if it is going to… but if it does happen, it’s not going to be ‘sell everything and move into your bunker’. There is going to be some time to analyse and re-evaluate what your [investment] goals are and what to do then.”