Every day brings new hyperbolic headlines about the trade war between the US and China. Both countries are each other’s biggest trading partner, so it seems like a cause for concern. While ongoing trade friction can lead to economic slowdowns for both countries, it’s no reason to make drastic changes to your portfolio.
Let’s start with the scope of the issue. The US is currently imposing tariffs on almost half of all goods imported from China, creating an astounding 25% tax on over $200 billion in goods. Beijing responded by placing tariffs on 90% of all US imports. The Trump White House warned that it might extend the tariffs to cover virtually all goods from China. Annual imports from China total almost $550 billion. Most economists expect these trade policies to create a small but noticeable drag on economic growth for both countries. Estimates for near-term impacts are about a 0.1% decline in GDP growth in the US and 0.4-0.5% decline for China. Trade is far beyond a two-player game, so this will also affect the broader global economy. Markit economists are predicting a slog on global Real GDP of 0.8% in 2019 and 1.4% in 2020 if the current trend of protectionist policies continues. They estimate that growth would remain only marginally above the level of a world recession if trade relations do not improve.
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While slowing growth may seem like a good reason to rebalance your portfolio, a trading strategy based on GDP would not be sound. Research shows that GDP growth and equity markets are not always highly correlated. This is especially true over short periods of time. You don’t want to introduce new risk and trading cost when the markets may not be in line with the expected GDP trend.
The above graph shows how large the trade with China has become for the US in the past few decades. This dataset is not seasonally adjusted but highlights the scale that has increased tremendously in the 21st century. The large trade deficit is the primary concern referred to frequently by Trump and the White House. Not only are the absolute numbers large, but this deficit impacts many facets of US economic growth. Imports from China include not only consumer purchases like electronics and textiles, but also many industrial inputs. Items like steel are used in many domestic production processes. Even when increases in prices don’t hit the consumer directly, they end up increasing the cost of production on many items that are manufactured in the US.
This broad impact of trade is, surprisingly, one reason why you don’t want to make emotionally driven portfolio changes right now. The drag on growth is widespread among industries and investor products, so there aren’t feasible strategies that would isolate a portfolio from the slowdown. Accepting a temporary slowdown of growth across a portfolio is better than trying to overly concentrate holdings. The extra trading costs alone could quickly add up to more than the lost growth.
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This chart shows the percentage of annual GDP that the United States and China get from trade. It should help highlight that, especially for the United States, trade has grown at a moderate pace as a share of total GDP since the middle of the last century. It took almost 30 years for the trade share of US GDP to get to 30% after reaching 20% in 1980.
Another highlight of the GDP data is the significant economic transformation that China has undergone in the past decade. They’ve managed to reduce the fraction of their economy from trade by over 50%. This decision has been part of a planned adjustment to make economic growth more resilient. Like many developing economies of the past century, China fueled much of its growth by selling goods to developed Western markets. It can be a great source of capital, but reliance on external markets makes one more susceptible to slowdowns caused by those countries. Over the past few decades, smaller economies that rely on capital from external sources have experience more procyclical patterns as they suffer more substantial downturns when foreign capital is withdrawn during periods of recession in home markets.
China has been very methodical about its growth and has managed how foreign capital is invested. They have instituted controls that require foreign companies to partner with domestic firms and have limitations on when capital can be withdrawn. This managed growth (along with a famously lax policy on intellectual property rights) has helped their domestic industries grow along with their international trade. Increasing employment and heavy investment in domestic infrastructure have contributed to a robust domestic consumption market and continue to be a major driver of Chinese growth. Chinese domestic consumption growth is in the low double digits compared to an expected 6.2% for the overall economy. This growth is one reason why China has increased purchases of some goods from the US in recent years (agricultural products especially).
The changes in China’s economy are one reason why the projected impacts from an extended trade dispute are not catastrophic. The Chinese government will continue trying to stimulate growth among its domestic consumption market even if trade with the US slows. You wouldn’t want your portfolio to miss out on growth due to concerns about global markets coming to a halt.
In addition to the reasons discussed above, it’s also likely that the current policies are temporary. The Chinese government has been pursuing several methods of expansionary fiscal policy to stimulate growth. They cannot achieve the levels of growth they desire without also keeping up foreign trade. There is much speculation about who might “win” a trade war between the US and China, but the reality is that neither side benefits from a sudden pivot to protectionism. The Chinese government only applies tariffs in retaliation to US policy. It is likely that they would remove them once the US does. Evidentially, they have done so multiple times over the past year.
One final bit of wisdom that is fitting now comes from the economist Herbert Stein, who coined Stein’s Law in 1976: “If something cannot go on forever, it will stop.” This succinct idea is based on the simple premise that a trend that seems impossible will be so. In the US, the current political and business climate is heavily in favor of ending the White House’s current protectionist streak. Even if the policies continue for the rest of the current presidential term, pursuing tariffs that slow growth and increase the cost of living for working Americans seems likely to lead to the election of new candidates who would end those policies quickly.