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Wait, Are Investors Suddenly Cheering For A Trade War?

The stock market is a conundrum, where sometimes the most bizarre explanation is the correct one. The trade war between the US and China dragged the entire market down in 2018. But stocks have rallied this year – even though the tariffs that worried investors last year haven’t gone anywhere. A closer look at the factors behind stocks’ surge suggests that in this case, investors may be getting too optimistic, too soon.

Tariffs are bad! No, wait, now they’re good?

In 2018, the commencement of the US-China trade war became the biggest market overhang, with more than $360 billion worth of goods between the US and China subject to tit-for-tat tariffs. As a result, world economic data slowed as corporations delayed making new investments. With the US airing grievances about structural components within China’s economic model, it seems unlikely that the two sides will reach a permanent trade truce. While President Trump signaled that he would extend the deadlines for Chinese tariffs beyond March 1, 2019 deadline, his 10% tariff on $200 billion worth of Chinese goods still remains.

So why have Chinese stocks surged for the first two months of 2019, with the CSI 300 gaining more than 20%? Valuations partially explain the rally: The CSI 300 is trading around 10 times earnings, a 30% discount from a year earlier, and slightly cheaper than the MSCI Emerging Market index at 11.4x.

However, the main reasons stem from a more dovish U.S. Federal Reserve (Fed) and its impact on other central banks. The Fed surprised markets in January by taking a more cautious outlook on the U.S. economy, after stating only one month earlier suggested that the US economy remained robust despite trade tensions or a record-long government shutdown.

A dovish Fed creates a spillover effect to other financial institutions, removing the tightening pressure caused by rate differentials between the US and other central banks. This includes central banks in Asia, which are also grappling with weaker economic momentum as a result of the trade war.

The US and China’s central bank respond to crisis

Given the structural challenges needed to fulfill US demands in the trade war with China, any truce between the two nations seems like it would have to be temporary at best. However, it appears that any uncertainty regarding the trade negotiations, provides an avenue for the Federal Reserve to maintain its dovish outlook, which keeps liquidity in the market, benefiting risky assets such as equities.

Investors should note that the Chinese equity rally also coincided with a record volume of credit being released. January’s new loans data reached 3.23 trillion yuan, while total social financing reached 4.64 trillion yuan. Both figures were higher than analysts’ expectations.

Though seasonality partially explains the pickup in credit, new loans data suggest that People’s Bank of China (PBOC) is also responding to the slowdown in the economy by keeping liquidity in the market. Given the response from both the Fed and the PBOC, should the US-China dispute carry further into the year, both central banks are likely to respond with looser monetary policies, which supports the market momentum.

Be ready if an agreement is reached

Right now, investors appear to be cheering for a trade war. But when fundamentals catch up, this market reprieve may prove short-lived.

Given all that, what happens if the U.S. and China hammer out a trade truce? With oil prices reaching a three-month high, and a tighter labor market creating wage pressure, in theory that should lift inflation expectations. Rising prices would also come as US consumers absorb the majority of tariffs on Chinese imports, and as US corporations have underinvested in the latest business cycle, leaving little spare capacity. This would all suggest that the Fed might return to a less dovish stance, similar to the end of 2018, which sent markets lower.

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