Institute Alert

Wells Fargo Investment Institute strategists provide insights on this week’s market volatility and guidance for what may be ahead.

May 6, 2019

Paul Christopher, CFA, Head of Global Market Strategy

China and the U.S. Raise the Stakes on Trade

Key takeaways

  • Over the weekend, the U.S. and China exchanged new threats over their mutual trade, and the new week opened with selling in risk assets, including global commodity and equity markets, as well as many international currencies.
  • These threats carry risks that either (or both sides) could miscalculate their way into new and economically damaging trade restrictions. However, we believe it more likely that the two sides are using leverage on one another to accelerate through the complex parts of their negotiations.

What it may mean for investors

  • The prospect of additional uncertainty requires some patience, but any extended weakness could prove to be another opportunity to add to allocations in risk assets.

Download the report (PDF)

President Trump threatened on Sunday to raise tariffs from 10% to 25% on $200 billion in Chinese products imported into the U.S. He also threatened a 25% tariff on another $325 billion in Chinese imports, including consumer electronics not covered by previous U.S. levies. In response, China may be weighing whether to cancel trade talks in Washington this week.

The main news is the new pressure for higher tariffs and the possibility of a breakdown in U.S.-China trade talks. But North Korea also used the weekend to test long-range rocket launchers and tactical guided weapons. These issues easily could be related. The U.S. buys more from China than China buys from the U.S., so tariffs are a main U.S source of leverage. For the Chinese, one main pressure point is its cooperation on the U.S.-North Korean denuclearization talks. The easing of tensions between North Korea and the U.S. came abruptly in 2018, while China was negotiating trade with the U.S.

While these threats remain concerns, global equities probably will lead the way lower. Taiwanese, South Korean, and Chinese equities have benefited from hopes for a trade deal during the past five months, and these could lead global markets lower in the near term. Commodities broadly could decline as well. In addition, the greatest currency depreciation should come among those whose economies depend the most on trade (e.g., the currencies of China, South Korea and others in emerging Asia, as well as the euro and the Australian dollar).

Analysis

The latest rhetoric arrived abruptly and unexpectedly, considering that reports this year generally indicated progress, even so far as suggesting that the complex enforcement mechanisms behind any trade deal could be finalized in early May. The fact that almost 100 Chinese officials were scheduled to come to the U.S. this week for additional talks signals that a deal was close and reinforces our view that President Trump is eager to push this deal over the finish line. For its part, China would not bring 100 officials to the table if a deal were still far off.

Our base case is that the U.S. and China are not walking away but are pushing to accelerate the final deal. We believe this scenario is very likely because of the great opportunity and risk that a trade deal poses for each country’s economic outlook. A deal could reinforce positive economic momentum, but new tariffs, or a breakdown in talks, could undermine that outlook quickly. Global trade is still weak and economic growth in both economies (and globally) could still slow, if these risks become realities. This is a risk to consider, but we believe it is a small probability, because each leader has strong domestic political and economic reasons to avoid the significant negative impact of a miscalculation.

Any new round of tariffs could also push more central banks overseas to cut interest rate targets and weaken their currencies. For example, the Reserve Bank of Australia could be the next to cut, and any additional economic slowdown could put more pressure on the European Central Bank. If monetary policymakers in other countries feel more pressure to ease policy, the U.S. dollar could strengthen. In turn, an appreciating dollar could adversely affect U.S. corporate overseas revenue and make dollar-denominated debt more expensive to refinance in emerging economies.

If talks don’t reopen on Wednesday, May 8, the threatened tariff escalation seems likely. In that case, global risk asset prices could decline further, and we would expect additional negative economic impacts over time. Throughout the tariff dispute, China has threatened to retaliate against all U.S. levies, although China has already imposed tariffs on almost all U.S. goods. If the U.S. does move to raise tariffs, China could retaliate in other ways, by raising existing rates, through nontariff barriers, or through new North Korean weapons testing.

What investors should do now

If the two leaders are indeed acting to cement a positive outlook by hastening a trade deal, then the latest round of selling could be short-lived in risk markets (commodities, equities, and international currencies other than the yen). In that case, any backing down from the latest threats, or a trade deal, could create a buying opportunity in risk markets. We will focus on areas with stronger fundamentals, such as U.S. large caps, which we rate as neutral, and emerging market equities, where we carry a most favorable rating. If a chance emerges to add to equities, we will look to use cash set aside earlier this year.

More broadly, the strategy we have been employing is to look for opportunities to rebalance when markets move significantly in either direction. When markets pull back, we will be looking for opportunities to put cash back to work in global equities. When markets rise steadily—as they did earlier this year—we will look to trim positions toward long-term target allocations. This is rebalancing, and it is a way to maintain those allocations, which we believe are the foundation for an investor’s long-term investment plan.

Risk Considerations

Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Currency exchange rates are frequently subject to intervention by governments, which can be difficult to predict and can have a significant impact on exchange rates. They are driven by complex factors relating to the economies of the relevant countries that can be difficult to understand and predict. Currencies issued by emerging market governments may be particularly volatile and will be subject to heightened risks. Fluctuations in exchange rates between the U.S. dollar and foreign currencies may cause the value of a portfolio' investments to decline. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility.

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