The US-China trade war entered its 16th month and doesn’t look to be ending soon. It continues to be a wildcard from an investment perspective—extremely important in the medium term but impossible to predict. It is therefore not a direct input into our investment process, but it does have an indirect impact by affecting the pricing models that drive our fundamental decisions across asset groups and stocks.
We continue to view the trade war as an opening salvo in what will be a new world order involving two nations with competing global visions and ambitions. Rationally, the trade war itself should remain a tactical negotiation, as both sides ultimately have incentives to drive economic growth and reach a favorable outcome (reelection for Trump, consolidation of power for Xi). Economic fallout appears manageable under most scenarios, but the threat of miscalculation is meaningful, given each country’s competing visions.
While the S&P 500 index hovers near all-time highs, it is not as optimistic as it seems; we believe the market is already pricing in some kind of protracted conflict. As the story has unfolded, investors have bid up stocks with high secular growth (part of a multi-year trend) or defensive characteristics to insulate them from potential fallout.
The problem is, these stocks are extremely expensive, according to our long-term fundamental pricing models. Anecdotally, the secular growth tech stocks trade at a whopping 67-times earnings (and as high as 179-times, and some with no earnings at all), and the defensive staples stocks trade at 33-times earnings on average, with underwhelming growth rates of 4%-8%. We view this as a narrow, tenuous market.
While our factor models indicate that investors have over-priced defense and growth, they point us to the more under-priced cyclical stocks with reasonable balance sheets and earnings trends, mid-sized and small stocks, and emerging markets. Many of these groups have become even more attractive from a risk-reward perspective as the trade war lingers. For comparison, they tend to trade at 8X-20X earnings (among other important criteria), with reasonable-to-healthy earnings growth profiles.
Importantly, investors should not chase today’s perceived winners, for two reasons:
- We have already set defensive allocations in client portfolios to anticipate these kinds of risks, so jumping into additional sectors out of fear is unnecessary.
- Long-term portfolio returns require taking advantage of cheaper stocks and asset groups with a better balance between price, growth outlook, and opportunity.
For those wanting a more detailed assessment of the trade war, we include our report below.
Trade War: Bumpy Path but Manageable?
To date, we have assumed—like most investors—that neither the US nor China wants a trade war that leads to recession. We still think that’s the case. We believe there are guardrails to decisions: for President Trump, stock market weakness and re-election offer constraints; for President Xi, managing China’s delicate economic challenges so he can consolidate power put bounds to his decisions. In short, both leaders need outcomes that favor economic growth.
That said, the market is also realizing that each side has appetite for a protracted dispute. The US has the stronger economy, but China can absorb some pressure through its favorable currency reserves, willingness to depreciate the Yuan, and high domestic savings. These have barely been tapped. There may be some downside to economic growth as the trade war lingers.
Current estimates are that announced tariffs—if implemented—would reduce US economic growth by 50 points, from perhaps 2.5% down to 2%. China could see a greater impact—perhaps a hit of 100 points, since the US is a meaningful 20% of China’s exports.
But the Stakes are Rising
The trade war is exposing signs of a deeper, more fundamental conflict between the US and China. The dispute over Huawei illustrates that the line between technology, independence, and national security is a deeply sensitive one. We see similar echoes with Alibaba’s reported interest in diversifying its access to capital markets away from the US. In theory, a partnership built on trust would strengthen collective research in tech; but in practice, distrust could create rivals looking to outmaneuver the other.
Similarly, mounting tensions between Hong Kong and China (e.g., the protests against heavy-handed legislation in mid-June) underscore how China’s political ambitions may directly clash with western economic/judicial systems. Hong Kong is an important bridge between western economies and China. China’s one-party rule and state-driven economic model may be at fundamental odds with many of Hong Kong’s pro-western traditions.
How the tensions evolve is anyone’s guess, but the risk of what’s called a “Zero-Sum Game” in negotiation strategy is clear, whereby one party’s desired outcomes are diametrically at odds with another party’s.
For the past 20 years, Western governments tried to incorporate China into the global trading system in exchange for domestic market-based reforms. That proposition has not worked well (hence, Trump’s tariffs). Instead, President Xi seems to be pursuing a strong global role independently, even as he strengthens the authority of the Communist Party and its commitment to a state-driven economic model.
It doesn’t have to end adversely, of course. The benefits of cooperation can improve technology, health, environmental controls, and global trade. Most importantly, it can expand the economic pie. But competing ambitions and nationalistic forces are powerful distractions. We hope that world leaders see the need to focus on mutually beneficial outcomes, rather than winner-take-all.
 Alibaba Group is China’s largest e-commerce company. It is listed on the New York Stock Exchange and completed the world’s largest IPO a few years ago. It reportedly filed for a listing on the Hong Kong exchange this fall, likely in anticipation of a large follow-on offering.
 In June, Hong Kong citizens held a three-day demonstration, at times violent, to oppose new legislation by the Hong Kong government. At issue was a proposed law to allow extradition of suspects under trial to countries like China. Recall that the United Kingdom transferred administrative control of the colony of Hong Kong to China in 1997. Hong Kong has its own government, but it is an administrative region under China’s control. At issue: how “pure” is the mainland’s judicial system under single party control? How strong are the ties between Hong Kong’s government and that of China? Will Hong Kong’s western traditions clash irreconcilably with China’s emerging state-controlled system?