Last month, we pointed to an acceleration in US growth, courtesy of the Trump fiscal boost, suggesting that it would not only extend the cycle beyond 2019 but also have dire inflationary implications, forcing the Federal Reserve (Fed) to push interest rates up by larger increments. The first reading of 2nd quarter US real GDP buttressed this view. Overall growth came in at 4.1% (on a seasonally-adjusted and annualised basis), well above the 2.2% recorded for the 1st quarter and almost double the pace in Europe. And the speeding-up of the economy was mainly domestically-driven: personal consumption grew a strong 4.0% and business fixed investment was particularly impressive, expanding by 7.3%.
Predicting a US recession as soon as 2019, when companies are just starting to invest after a decade of post-financial crisis restraint and the infrastructure spending component of public stimulus has yet to materialise, is anathema to us. Rather, we see the US engine continuing to fire on all cylinders and expect Fed Chairman Powell to stay the course – irrespective of President Trump’s recent attempts to interfere. By incrementing its target rate by quarterly steps of 25bps, the Fed currently considers 2.9% as the equilibrium rate. We, however, think this might not be high enough to tame the American beast. Rates will rise across all maturities, driving an upward shift (but no inversion for the foreseeable future) of the yield curve and US dollar appreciation. Needless to say, higher rates will exert downward pressure on equity valuations.
The ongoing trade dispute constitutes the only threat to this sanguine 2019 view of the US economy. Just over USD 500 billion of goods were exported from China to the US in 2017, a mere 3% of Chinese GDP. Thus, even if the Trump administration were to push through with tariffs on all of those goods, the impact on the Chinese economy would be minimal. Meanwhile, potential retaliatory action by Chinese policy makers – for instance a suspension of part or all commerce with the US – would inflict severe damage to the US economy. The important point here is that China can find an alternative source for all of its imports from the US, while US companies’ value chains (notably in the IT space) are very dependent on Chinese manufacturing (Apple's IPhone is made in China).
All told, we see only two possible outcomes to the US-China trade dispute. Either the US administration backs down, realising that it is the weaker of the two opponents – and perhaps also surrendering to internal pressure from the farming, car manufacturing and IT communities. Of course, this would have to be done in a way that avoids President Trump losing face ahead of the mid-term elections. Or else the conflict turns military, with fighting in the South Chinese seas. This could occur if China were to act rashly in suspending exports to the US and the US in turn consider their national security to be endangered. It is not an outcome that we deem likely, to the extent that Chinese authorities have demonstrated time and again their patient, well thought-out and long-term approach – and ultimately know that they hold the upper hand.
Fastest US growth since 2014
Chart 1: Source https://research.stlouisfed.org
It is admittedly only an “advance estimate”, but the recent 2nd quarter GDP report did confirm what we suspected: the US economy is on a tear. Real growth in excess of 4% had not been experienced since the latter part of 2014.
Moreover, the 4.1% overall growth was broad-based, with the slower pace of inventory accumulation as the only detractor (essentially offsetting the 1.1% positive contribution from net exports). Domestic final demand increased by an impressive 3.9%, driven by a 4.0% increase in personal consumption and a 7.3% pick-up in business investment.
As regards the consumer component, it is interesting to note that the official data set for the personal savings rate recently underwent considerable revision. Previously assessed at just over 3%, it is now estimated to be close to 7%, providing further fuel for consumer spending during the coming quarters.
On the corporate side, all lights (save for possible side-effects of the trade dispute on business confidence) are now green for investing in productive capacity. US earnings are strong thanks to solid sales growth and the lower corporate tax rate, spare capacity has been almost fully resorbed, and repatriated foreign profits (another benefit of tax reform) are looking for somewhere to go.
In the non-industrial space, particularly the so-called FAANG companies (Facebook, Apple, Amazon, Netflix and Alphabet’s Google), repatriated capital is no doubt being affected to share buybacks – regardless of the obvious overvaluations. This year alone, according to Goldman Sachs, share buyback plans worth over USD 1’000 billion will be announced. In doing so, these US market heavy-weights are fuelling the upward move in the indices, particularly on the NASDAQ exchange, and forcing ever-growing index funds to follow suit. That is, until the music eventually stops. Not to mention possible investigation by regulators of the apparent conflict of interest when members of management sell paper just days after their company has announced a buyback program. (Cf. link : Stock Buybacks and Corporate Cashouts)
Reflections on the US-China trade dispute
In thinking about the trade dispute, it is important to remember how large the Chinese economy has become. The country’s GDP is expected to reach USD 14 trillion in 2018, not only gradually closing in on the US (whose GDP is estimated at around USD 20 trillion) but also putting into perspective the ca. USD 500 billion of Chinese exports to the US.
That all this “fuss” effectively pertains to only 3% of Chinese GDP highlights the fact that President Trump’s crusade against China – which is supported by the US Congress, unlike other measures targeted at Europe – is occurring too late.
It is quite true that China does not play a fair game, that it has little respect for intellectual property rights and that it hinders foreign company access to the local market. But that war should have been waged many years ago, when the Chinese economy was much more dependent on exports.
Not only are the US measures striking too late, they are also not the appropriate ones. By antagonizing China with tariffs on (soon perhaps all) goods exported to the US, President Trump risks causing greater damage domestically than in China.
Beyond “tit-for-tat” tariffs (on an admittedly smaller amount of US exports to China), Chinese policy makers could attempt to disrupt US companies’ supply chains, by limiting production at partner Chinese companies or simply suspending trade with the US. The most affected sector, as illustrated in chart 2, would clearly be Information Technology, notably semiconductor and hardware companies.
Chart 2: Source BCA Research