Here we go again...
After two consecutive days of sharp downturns in the US stock market, headlines have fixated on a potential “trade war” between the US and China as the decline’s putative cause. We believe otherwise.
Trade and “Trade Wars”
There are many important aspects of international trade that could take up many pages, but suffice it to say that the dollar amounts mentioned in the current US-China trade spat are ultimately quite modest. US President Donald Trump has proposed to increase tariffs on about $50 billion worth of US imports from China, and China has threatened to retaliate by imposing higher tariffs on about $3 billion of US exports to China. What does $50 billion of imports from China mean in the broader context of the US economy? The chart below shows exports and imports in 2017 for the main US trading partners. Total imports from China were just over $500 billion, so even if the proposed tariffs were so extreme as to cause the entire $50 billion to not be imported from China, the foregone imports would represent only 10% of all imports from China, 1.7% of imports from all countries, and only one-quarter of one percent of America’s $20 trillion economy. Equally important is that the imports wouldn’t “disappear” but rather would be produced less efficiently, either domestically in the US or in other countries unaffected by the tariff.
We can’t read the minds of those sellers who pushed US share prices down nearly 5% in the last two days, but the loss of economic efficiency from tariffs that affect at most 0.25% of the US economy doesn’t seem to be a very plausible reason.
Volatility is Back
A better explanation for the last two days is that volatility (choppiness) returned to stock markets this February, and as volatility increases, both increases and decreases become larger. This sounds like circular reasoning: stocks are choppier because they are choppier. However, the chart below indicates that other than for two very extreme days early this February, the heightened volatility of the last several weeks (the burgundy bars) seems much more normal than the unusual calm that preceded it in the latter part of 2017. In short, late 2017 was the exception, not 2018. Moreover, the blue line indicates that despite their recent decline, US share prices are at about the same level they were last November.
Other Important Context
The US central bank (the “Fed”) this week increased its short-term interest rate target another quarter-percent. The strong US economy allowed the Fed to continue “normalizing” interest rates, which were slowly increased over the past two years but which remain below inflation and also well below their levels prior to the 2008 global financial crisis and resulting recession. Essentially, interest rates are higher but are well below the levels that may trigger a recession. Job growth was very strong in the first two months of 2018 and initial unemployment insurance claims remained close to record lows into mid-March. The US economy is firing on most, and perhaps all, its cylinders.
The stock market gyrations of the past few days belie simple explanation, other than perhaps that the more normal levels of volatility that returned to stocks in February are here to stay. The much-hyped US-China “trade war” explanation doesn’t hold much water, given the small amounts of trade being considered for increased tariffs. However, the overall environment – modest and measured Fed increases to its target interest rate, predicated on a very strong American economy – give us reason to believe that the stock price volatility is not a harbinger of a slowing economy, but is just part of the normal fluctuation that confronts equity investors.
What we know is that stock prices fluctuate, sometimes very significantly. What we also know is that it’s crucial to largely disregard their short-term fluctuations, in order to reap the benefits of stocks’ higher long-term returns.
Chief Investment Officer, ATB Investment Management Inc.
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