Last week was not great for investors, and the market mayhem continued Monday. As the China trade talks broke down Friday, investors were scurrying to figure out what it all meant. In this post, we will discuss the cause of this recent turmoil, what we might expect in the near term, and take a brief look at the U.S. economy.

Last Week in Review

Stock prices declined last week by 2.12% (DJIA closing levels from May 3rd to May 10th). Why did the market react so negatively? Investors assumed a trade deal would be reached, which was priced into the market. The expectation of an agreement has been one factor propelling stocks higher. When an agreement seemed in doubt, selling pressure rose and stock prices fell. I believe there will be an agreement at some point. China’s economy is heavily dependent on exports and needs a deal more than the U.S needs it.

To illustrate, the four components of U.S. GDP are consumer spending, business spending, government spending and net exports. The following chart shows how much each has contributed to total GDP (SAAR) from June 30, 1947, through March 31, 2018. Note that consumer spending is easily the most important while net exports are the least. Therefore, it is this authors opinion that a trade deal, though important, is not as important as the U.S. markets seem to indicate. Conversely, the Chinese economy relies heavily on exports. In fact, in 2018, Chinese exports declined 2.7% and the Chinese economy experienced its weakest GDP growth rate in 28 years.

What caused the initial and ongoing turmoil?

The Tweet

Sunday afternoon, May 5 – in advance of the May 10 trade meeting with Chinese officials – President Trump went on the offensive (which may have been a bit offensive to China). In a tweet, he stated he would increase tariffs from 10% to 25% on $200 billion of Chinese exports. He further stated he would impose a 25% tariff on an additional $325 billion in Chinese exports “shortly.” Understandably, investors became nervous. The following chart shows the market’s reaction. In it, we find the daily movement of the Dow Jones Industrial Average from Friday, May 3 to early Thursday morning, May 9. Notice where it opened and closed each day.

Because of the Trump tweet, the DJIA opened 465 points lower on Monday than it had closed the previous Friday (A). While Chinese stocks fell about 5.0% Monday, the DJIA rebounded, losing only 66 points or 0.2%. That was a very good sign. The following morning (Tuesday), the DJIA opened lower, but to a lesser extent. Unlike Monday when it rallied, stock prices fell sharply throughout the day. Wednesday’s opening was about the same as Tuesday’s close (another good sign). Thursday morning stocks opened lower than Wednesday’s close (C). Thursdays close to Friday’s opening was not much different (not shown) and this morning’s opening was significantly lower than last Friday’s close, as stocks continue to tumble.

While I believe this is a lot of noise, I still believe the negative reaction is overrated and we will look back at this as another bump in the long and winding road. I do not believe the road will wash out! Perhaps the difficulty lies with U.S. companies that have deals in place with China to provide various goods. Depending on the terms of these agreements, it could lead to higher consumer prices. This is a primary concern.

To understand why the president would tweet as he did, we must understand the strategy behind it.

The Strategy

As mentioned, the U.S. economy is primarily driven by consumer spending, which accounts for nearly 70% of total GDP. China’s economy is primarily driven by exports. In short, China needs to sell. Therefore, when the U.S. (or other nations) increase tariffs on Chinese exports, it causes a slowdown in the Chinese economy because tariffs make Chinese products more expensive for the rest of the world. This strategy is designed to bring China to the table. Has it worked? Absolutely. You see, China’s economy has indeed slowed, which has prompted its leaders to discuss a new trade deal.

A Brief Word on Tariffs

Tariffs are not inherently bad. For instance, they can provide leverage between nations in a negotiation. That will become clear in a moment. It’s true that without tariffs, the price we pay for many imported goods would be lower. But isn’t that a good thing? Yes … but … that would also cause a radical change in the business climate in the U.S. as companies would be unable to compete.

Moreover, a complete absence of tariffs could result in widespread layoffs and business closings, which would have a dire effect on our standard of living. Perhaps more relevant is that the U.S. enjoys a much higher standard of living than the rest of the world. For example, median household income in the U.S. was approximately $61,372 compared to China’s $10,964 (CY 2017-USD). Since Chinese workers need less income to survive, labor costs are much lower than in the U.S.

Why is President Trump pounding the desk so hard? The following chart may provide some answers. As you can see, the U.S. is China’s best customer. In fact, the U.S. and Hong Kong together import more Chinese goods than the next nine countries combined. Therefore, the U.S. has the most leverage.

Tariffs may be here to stay, but how much is too much? If higher tariffs continue for a short period, the effect will be minimal. If this continues for a longer period, it may result in higher prices for consumers. If that causes a significant reduction in consumer spending, it could result in a weaker U.S. economy. This is basically a game of “who will blink first” or perhaps, “who will need to blink first.”

The U.S. Economy

The U.S. economy is strong. Real GDP growth is around 3.0%, unemployment is at 3.6% (a 30-year low), inflation is under 2.0%, and corporate profits are strong. In fact, there are more jobs than workers. To sustain U.S. GDP growth, we need about 100,000 new jobs per month. We have been averaging over 200,000.

Summary

I believe the strong U.S. economy will provide support for stocks until the next recession draws near. Yes, there will be bumps along the way, but I wouldn’t expect a major correction yet. Of course, if the trade deal falls apart, stocks are likely to fall, but with the strong backdrop of our economy, it should be temporary. Although that’s logical, the stock market is usually illogical. This may be a good buying opportunity. We’ll see.