Market sentiment turned notably bearish in May following a breakdown in U.S./China negotiations
The Trump administration also decided to “weaponize” trade versus Mexico to affect immigration policy
The markets had largely been focused on the inflation trend as it relates to a potential shift in Fed policy, but all eyes are on trade for now
For much of 2019, it appeared that U.S. and Chinese officials were close to reaching a comprehensive trade agreement, and global risk markets were effectively priced as such. However, things took a turn for the worse in May, sparking a risk-off trade and sending intermediate and long-term Treasury yields more than 35 basis points (bps) lower on the month. The shift in investor sentiment was initiated by a tweet from President Trump on May 5. Trump expressed frustration that the talks with China were moving “too slowly as they [China] attempt to renegotiate.” As a result, he said the United States would be increasing the tariff rate to 25% on more than $500 billion of Chinese imports by the end of the week if China did not meet U.S. demands. This caught investors by surprise and sent risk markets reeling when markets opened on Monday, including a 5% decline in Chinese stocks.
In the days that followed, there was much analysis as to what caused the sudden shift. With recent U.S. economic data better than expected (Q1 GDP and April jobs report were strong) and stock market performance solid, Trump may have seen an opportunity to push back on criticism that the White House may be relenting on its original demands and accepting a less robust agreement with China. However, Reuters reported that Chinese officials had “backtracked” on essentially all major U.S. demands, including intellectual property theft, forced technology transfer, competition policies, and currency manipulation. The next day the Wall Street Journal presented a theory on why Chinese officials “backtracked” on their commitments. According to sources “familiar with the thinking of the Chinese side,” Beijing interpreted recent statements and actions by President Trump as a sign the U.S. was ready to make concessions. More specifically, Chinese leaders viewed Trump’s badgering of Fed Chair Powell to cut interest rates and expand the Fed balance sheet as evidence that the president thought the U.S. economy was more fragile than he claimed. “Why would you be constantly asking the Fed to lower rates if your economy is not turning weak ,” said Mei Xinyu, analyst at a think tank affiliated with China’s Commerce Ministry. Of course, the Chinese have pushed back on this reasoning, with local media reporting that negotiations collapsed because U.S. officials attempted to add new demands in the final hours of negotiations.
No one knows for sure what led to the breakdown in the talks, but tensions escalated as the month progressed with the U.S. going after Chinese technology firms. More specifically, President Trump signed an executive order on May 15 effectively banning Chinese telecom giant Huawei from selling equipment in the U.S., and the Commerce Department said it would add Huawei to its listed of entities engaged in activities contrary to U.S. interests. The latter is a bigger deal that would restrict the sale of U.S. equipment to Huawei, particularly processing chips that it relies on from U.S. suppliers. Not surprisingly, this action infuriated the Chinese government, and it responded later in the month with threats to “weaponize” its supply of rare earth minerals to U.S. companies (and other buyers). China commands much of the market for these minerals, used for products ranging from iPhones to missiles, because they have been more willing than others to refine those minerals from ore, which can be expensive and polluting. This threat is not new. China has been considering this threat for some time, and as a New York Times article pointed out prior to this announcement, using these minerals as a trade weapon is likely more bark than bite. It’s basic tit-for-tat: you restrict our large telecom company from buying chips from U.S. companies, and we’ll restrict the raw material you use in the production of those chips.
The basic unknown at this point is which side will flinch first between the world’s two biggest economies, and things got even more concerning for market participants at the end of the month on a separate front. President Trump surprised everyone by announcing new tariffs against Mexico in an effort to force the country to curb immigration flows across the border. This was a big development because it shows a willingness to exploit trade to achieve other policy goals. The markets were understandably spooked by the announcement, and as some analysts opined, a weaker Mexican economy due to tariffs should theoretically only increase the number of citizens trying to cross the border to find work. Nevertheless, the more pressing question at this point: how much economic damage will be done before these trade skirmishes are resolved?
Global growth had already been skittish, and while the United States has been the best performer of the largest developed economies, the recent data have been mixed. The initial estimate of Q1 GDP was good at the top line, but the underlying components weren’t necessarily as good, particularly for current quarter growth. The April retail sales report was underwhelming, but on a positive note, the April housing starts report was better than expected, leading some analysts to predict that the sector will contribute positively to GDP in Q2 after subtracting from growth for the prior five quarters.
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