Protectionism once again stole the limelight on May 5th when Trump’s tweet reignited slumbering trade war concerns. Until that point global markets had slipped mostly back into complacency, fuelled by a now dovish Fed and a stimulating China, and with consensus by and large expecting an imminent trade deal signing ceremony. The S&P had fully recovered from a torrid Q418 to make new highs whilst the MSCI EM had posted a more modest yet still clear recovery. Back at home, South African equities were enjoying a reasonable start to the year, marginally outperforming the MSCI Emerging Markets. Sanity appeared to be prevailing. The re-emergence of trade war fears has however resulted in the cautiously bullish first half outlook now taking a turn for the worse.
The context for the escalation in trade wars is not favorable albeit arguably somewhat better than last year. Global PMI’s continue to fall and fears of slowing growth are once again front and centre. That said, at the onset of trade wars in 2018 there were a number of uncertainties regarding the likelihood, quantum and potential effect of China stimulus in the face of stimulus versus reform rhetoric. As things stand currently, this policy uncertainty has ameliorated with China showing no hesitancy in stimulating (including an RRR cut, total social financing of 8.5% of GDP as well as tax breaks) and the accompanied hard landing fears easing. Likewise the Fed has turned from hawkish to decidedly dovish.
What has not changed is the uncertainty and accompanied negative sentiment that accompanies the trade war and which is symptomatic of the broader increase in nationalist and populist sentiment. Many analysts have taken a stab at quantifying the economic and financial casualties of the trade war. For example, maintaining the status quo of 25% tariffs on $200bn of US imports and 5% to 25% on $60bn of China imports, is expected to reduce China’s GDP by between 0.3% to 0.5% and the U.S.’s GDP by between 0.1% and 0.3%. A 4x multiplier impact on earnings has been postulated by some analysts.
Whilst theorising about the actual quantum of the impact can be useful for providing context, the only thing we know for sure is that both the quantum of the trade war effect on real economies, as well as the potential timing of either its final resolution or further escalation, is incredibly uncertain. It is this uncertainty that we believe will ultimately have the biggest impact on equities both in terms of exacerbating a loss in business confidence and hence eventual economic impact as well as an increase in volatility and risk premium. South African equities and currency remain exceptionally vulnerable to capital flight under such uncertainty.
What we expect: In short we expect the trade war to get worse before it gets better. Despite the caveats alluded to earlier, we do not believe that equity markets yet reflect the risks inherent to either a continuation of the current status quo or the possibility of an escalation. The S&P 500 is just -4% off its recent highs and US activity indicators are holding up relatively well. To a certain extent we think the markets reflect a chicken and egg scenario. On the one hand, the current role players are not motivated to come back to the table whilst markets hold up, whilst on the other hand markets are holding up in anticipation of a near term (possibly G20 late June) solution. Something has to give. For now we think the risk lies with the market although the impending second half U.S. electioneering may change this dynamic.
For the rest of the year we would assign the greatest probability (40%) to a continuation of the current status quo with no deal, no escalation and negotiations dragging on. We would assign a 30% probability to a deal being struck and tariffs scaling back over time. Finally we also assign a combined 30% probability to an escalation in the trade war. This we split into a 25% probability of Trump extending tariffs to the additional ~$300bn in imports and a smaller 5% probability to a full blown escalation including tariffs on auto imports.
What is clear is that a broad range of outcomes are possible, whilst the motivation of the key role players remains opaque. What is also clear, is that most of these possible outcomes are likely to pressure risk assets with only one (scaling back of tariffs) potentially positive.
With this in mind, valuations globally as well as locally are not yet particularly attractive. The S&P 500 price to earnings, trading at 17x (Bloomberg) is almost one standard deviation above its 15yr average of 15.8x, or more or less in line with its longer term 25yr average of 17.2x. The MSCI Emerging markets index is currently trading at 11.9x (Bloomberg), broadly in line with its 14yr average.
Finally, the FTSE/JSE Shareholder Weighted Index (SWIX) has underperformed the broader Emerging Market index since the May 5th tweet (-9.3% vs -7.2%) hampered by recent idiosyncratic stock events, notably Sasol, Massmart as well as Naspers’s exposure to the parallel U.S / Chinese tech cold war brewing as collateral damage to the trade war, but at 12.4x (Bloomberg) it is marginally cheaper than its longer term average of 13.4x.
Given the above we remain neutral on domestic equities and cautious offshore equities. Likewise, locally we retain a preference for quality rand hedges over both China dependent demand stories as well as domestic GDP recovery themes. Longer term we think China stimulus could once again create opportunities in the resource names with a recovery in the domestic growth names taking somewhat longer.