US stocks ended the first quarter down 0.76% for the year. That mildly negative statistic understates the volatility we experienced since markets made all-time highs on January 26th.
The above chart of the S&P 500 shows ‘Up Days’ as green bars and ‘Down Days’ as red bars. For much of the last 6 months, stocks enjoyed a gentle rally in anticipation of the boost to corporate profits contained in the December 2017 tax bill. Indeed, stocks gained another 7.5% in the first three weeks of 2018, which is normally the gain of a whole year.
Unfortunately, investors became worried that inflation would surge, causing the Fed to raise rates rapidly and hurting stock market valuations in the process. That worry caused stocks to drop 10.1% in the first week of February. This was the first correction since January 2016. Before that, the last correction was in August 2015. We forget that corrections (selloffs of at least 10%) come along, on average, once every 18 months, so to have a correction after 24 months is quite normal.
Markets quickly regained higher levels by the end of February, but then came the ‘Tweet Storm’ starting with the below tweet:
Investors, however, are less confident that trade wars are ‘easy to win’. Investors know that US companies have spent decades developing sophisticated supply chains that crisscross the planet, always seeking the best manufactured products at the lowest cost. Arbitrarily boosting the cost of inputs by applying tariffs of 10-25% massively disrupts these supply chains. As a result, the initial estimate is that for every job in US steel that will benefit from tariffs, 7 jobs in manufacturing dependent on steel will be harmed.
Falling through March and into the first week of April, stocks are back at the lowest level of the year.
Let’s Examine The Actual Facts Of The US Trade Deficit
In 2017, the US goods deficit increased to $811.2 billion, up 7.8% from 2016. The US services surplus decreased to $242.8 billion, down 2.0% from 2016. The net trade deficit (or current account) increased to $568.4 billion, up 12.6% from the previous year. The decline in the current account is offset by gains in the capital account, which records net investments by foreigners into the US. Last year, foreign investors - mostly European but 20% Chinese - invested $568.4 billion in US companies, real estate, stocks and bonds. The trade deficit with China in 2017 was about $340 billion. China purchased $126.5 billion in US Treasury debt, and now holds $1.2 trillion out of total foreign held debt of $6.3 trillion, and total debt of $21.1 trillion.
In general, people fear that trade deficits harm a country. For example, from 1989 through 2017, US manufacturing jobs fell 5.5 million which, taken at face value, seems to be clear evidence that trade deficits are bad. Except that, in the same time frame, the US added 46.1 million service jobs resulting in a net gain of 40.6 million jobs (an average of 1.45 million jobs per year). In the last two years, US job gains have averaged 2.4 million per year.
Employment in manufacturing peaked in 1979, producing goods valued at $900 billion (in 2009 dollars). Last year, the manufacturing industry employed 7 million fewer workers than at the 1979 peak but it produced goods valued at $1.9 trillion. How is this possible? By one study, 6.1 million of those jobs were lost to automation and only 900,000 to offshoring. In general, significant productivity gains translate to higher worker incomes. In recent years, productivity stagnated and so did real wage growth.
Let’s look at the argument that manufacturing jobs are ‘more valuable’ than service jobs. Certainly, making $16.12 per hour as an auto assembly line worker is more attractive than making $8.25 per hour working in food service. However, it’s not more attractive than earning $21.39 per hour working as a computer programmer or $29.12 per hour as a registered nurse. The implication of these statistics is that the US should worry less about creating manufacturing jobs and worry more about raising educational standards to train young people for high value service jobs.
Is China Really The Bad Guy?
Another issue with labeling China as the bad guy in trade is that China acts more as an assembler than as a manufacturer. For example, an iPhone is shipped from Shenzhen in China but the iPhone’s parts are assembled in factories owned by Foxconn and Pegatron (headquartered in Taiwan) from parts sourced in other countries.
The iPhone’s parts come from the United States (Corning, Bosch Sensortech, Cirrus Logic, Qualcomm, Broadcom, Murata), Japan (Sony, Compass, Sharp), South Korea (LG, Samsung), Taiwan and other parts of China. Even Switzerland is on the list because Swiss company STMicroelectronics produces the gyroscope that tells your phone its physical orientation.
In other words, although China gets tagged with full value of the export, 75% of the value was in fact created in other countries.
There is another explanation for the widening trade deficit. The United States emerged reasonably quickly from the 2008-9 recession but Europe, Japan, Africa, and South America remained in a depressed state until about the end of 2016. American consumers had money to spend while consumers in depressed economies did not, so it made sense that more goods would flow into the US. At the same time, the dollar was rising relative to world currencies which made buying overseas more attractive.
However, while the US dollar is in decline (down 12.6% since January 2016) demand is picking up elsewhere in the world. The shift makes US goods more competitive overseas except in China as the Renminbi is pegged to the US Dollar. The deficit may be self correcting.
Who Wins In A Trade War, China or the US?
It’s hard to believe that China only joined the modern world economy in 2001. At the time it was ranked as the 6th largest economy behind France (Nr 5) and the United Kingdom (Nr 4). By 2009, China was the 3rd largest economy in the world behind the US and Japan. At present, China is Nr 2. Its economy is 65% of the size of the US economy, 259% of Japan, 333% of Germany and 492% of the United Kingdom.
We can reasonably project that sometime around 2028 - 2035 the Chinese economy will be the same size or larger than the US economy. It’s simple math: take 1.379 billion Chinese people, give them the tools to match 326 million Americans in productivity and voila! While the US government desperately tries to revive the American coal industry (current employer of 52,100 miners), in 2017 the Chinese invested $44 billion in wind and solar farms, electric cars and high capacity businesses. Major cities in the US are car-choked gridlocks of failing infrastructure while China plans $112 billion in rail investments and investments of $15 billion for airports in 2018 alone.
Doesn’t the US intend to spend $1.5 trillion on infrastructure over the next ten year? Yes. It’s a nice idea, but the concept is that the Federal government will seed state supported projects with $200 billion while the states come up with the rest. In order for that to go ahead, Congress first needs to authorize the additional spending. This is a hard sell given that the US federal debt grew by $1 trillion in the first year of the Trump administration. In other words, we expect NO acceleration in US investment in infrastructure from the current proposal.
Why are we bringing this up? Because at this point in time, the US is far more dependent on China for both manufactured goods and investment capital than we’re willing to admit. We imagine that the Chinese government already war-gamed what tariffs China would apply if the US government came after them. Indeed, in response to President Trump’s statements, China immediately announced retaliatory tariffs against soy beans (the largest agricultural export to China), ginseng (85% of ginseng exports to China come from Wisconsin, home of Speaker Paul Ryan), tobacco and whiskey (which hammers Kentucky, home of senate majority leader Mitch McConnell), automobiles (Michigan) and pork (Iowa). President Trump is now in a position where he either backs down on the tariffs (and loses face) or stands firm (and loses control of the House of Representatives).
Meanwhile, the US backed out of the Trans-Pacific Partnership (TPP) last year, essentially ceding the Pacific rim economies to China. China can readily replace US goods and agricultural products from Canada, Mexico, South America, Australia and New Zealand, and also from Africa. The US could end up paying more for the goods we must buy from China, while losing our single largest export market. This would cause the United States to plunge into recession.
Bottom line: it’s going to be a rocky year for the stock market.