The U.S.’ ongoing trade war with China has become more than background noise for investors and corporations. To recap some of the key developments, on September 1st, the Trump administration imposed a 10% tariff on an additional $300 billion of Chinese imports. The move followed May’s announcement of a new 25% tariff on $200 billion of Chinese goods, and retaliatory measures by China that could affect up to $75 billion of U.S. exports. Then, in late September the administration announced it was looking into ways to stem Chinese companies’ access to U.S. capital markets.
After inconclusive meetings in September and October that aimed at reaching a new trade agreement between the two parties, anticipation and concern in the runup to talks planned for later this month, are running high. Uncertainty regarding economic impacts and China’s potential response has led to wild gyrations in stock markets and growing cautiousness from U.S. corporations, which are now pulling back on long-term expansion and investment plans.
While it will take time for the negative effects of the tariffs and any counter actions from China, to work their way through the economy, the chief concern right now is the potential for the trade dispute to expand to the point it damages the global economy.1 Given the risks, we considered a couple of scenarios should the trade war start to negatively impact the U.S. economy beyond the loss of corporate confidence it’s already prompted. We also consider how marketplace loans stack up versus other investable asset classes.
Trade war gaming: potential outcomes
- Growing negative economic headwinds for both sides lead to a negotiated settlement. The global economy is already showing signs of a slowdown. On top of that, financial markets have reacted negatively to each sign of a ratcheting up of the trade war. That suggests both the U.S. and China have a strong interest in cooler heads prevailing. Still, the road to that outcome may be long and winding. In the interim, we could see:
- Periodic flights to safety in bond (increased demand for U.S. Treasurys) and equity markets (selloffs and/or retreats to defensive stocks);
- More U.S dollar appreciation as investors seek safe haven assets;
- Additional Fed rate cuts given its pledge to “act as appropriate to sustain the expansion.”
- Increased recession risk is the chief concern most economists express.2 While many economists and bank strategists are sounding cautious notes, several see limited risk of the creeping trade war triggering a recession in the U.S. absent a dramatic increase in the tariffs’ reach.3 For instance, Morgan Stanley’s strategist puts the tariff tipping point at 25% of Chinese imports versus the current 10% as a necessary precursor to a trade war-induced recession. This view hinges in part on the assumption, so far validated, that the Fed would act aggressively to prevent a recession. For now, the economy still appears to be relatively healthy overall. Consumers in particular, have maintained their resilience. (That said, if the historically low unemployment rate ticks ups, consumer health could falter.) The industrial sector looks more vulnerable though, with both exports and capital spending down.4
- A destructive competitive devaluation is another possibility if the trade dispute is sustained. Currency wars, as economic powers seek a trading advantage have occurred several times in the past century. The most financially devastating one occurred in the 1930s, helping to spark the Great Depression.
How do we know which scenario will play out? It’s unclear, and there are no recent parallels for trade wars. Trade disputes have typically ended up at the World Trade Organization. Whether either party would go that route now, is unclear. Political posturing in the runup to the 2020 presidential elections in the U.S. presents yet another wildcard.
For now, neither China nor the U.S. appears to want to expand their dispute to the currency arena, making a competitive devaluation appear even more unlikely. In any case, successfully pushing down the U.S. dollar would face long odds, especially without participation from the Fed and at least some of the U.S.’ major trading partners.
(Marketplace) Loans, Trade Wars, and Bear Markets
Financial markets tend to respond to uncertainty or external shocks by bidding up defensive and so-called countercyclical assets. These could be government bonds from highly-rated sovereigns, dividend-paying stocks, commodities such as gold, real estate, or consumer staples. Should investors follow their typical course, retreating to “safe” assets in a downtown,5 marketplace loans’ distinctive features may make them an attractive asset class, particularly given consumers’ so far solid footing. Consumer health, and loan loss rates, would of course be negatively impacted in a recession scenario.
- Low correlation. Historically, marketplace loans have shown low correlation to equities and corporate bonds.
- Short duration. Given their typical durations of 1-3 years (versus just under 6 for the BBG Barclays Aggregate Bond index, as of August 2019), marketplace loans should show less price fluctuation than other types of bonds during periods when interest rates are falling.
- Regular principal and interest payments. These features provide predictable cash inflows during the term of the loan and could help offset volatility in other areas of the portfolio.
How the trade war plays out from here is impossible to predict. And of course, financial markets, and consumers, are affected by a myriad of other dynamics beyond trade uncertainty. But marketplace loans’ inherent characteristics—short duration, low correlation with more traditional asset classes, and regular cash payments—mean including them in portfolios may aid diversification, potentially providing a measure of resiliency, when market conditions change.
- Federal Open Market Committee, “Minutes of the Federal Open Market Committee,” https://www.federalreserve.gov/monetarypolicy/fomcminutes20190918.htm, September 17-18, 2019.
- Reuters: “Trade war escalation nudges U.S. closer to recession: Reuters poll,” https://www.reuters.com/article/us-usa-economy-poll/trade-war-escalation-nudges-u-s-closer-to-recession-reuters-poll-idUSKCN1UZ00F, August 8, 2019.
- CNBC Market Insider, “Wall Street is becoming convinced the trade war is here to stay and will only get worse,” https://www.cnbc.com/2019/05/23/wall-street-is-becoming-convinced-the-trade-war-is-here-to-stay-and-will-only-get-worse.html, May 23, 2019; and Barrons, “The U.S.-China Trade War Intensifies Here’s What Wall Street Is Saying,” https://www.barrons.com/articles/trade-war-analysts-recession-tariffs-economic-growth-51565037283, August 5, 2019; and Moody’s Analytics, “Trump Trade War: An Uneasy Truce,“https://www.moodysanalytics.com/-/media/article/2019/trade-war-update.pdf, January 9, 2019.
- U.S. Department of Commerce, U.S. Census Bureau, “Monthly U.S. INTERNATIONAL Trade in Goods and Services, September 2019,” https://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf, November 5, 2019; and Bureau of Economic Analysis, “GDP Increases in Third Quarter,” https://www.bea.gov/system/files/2019-10/gdp3q19_adv_fax.pdf, October 30 2019.
- Federal Reserve bank of New York Staff Reports, Staff Report No. 723, “Nonlinearity and Flight to Safety in the Risk-Return Trade-Off for Stocks and Bonds, “ “https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr723.pdf, November 2017.