Sorry to be such a downer, folks.
We have to stress test the macro scenarios versus current market conditions by looking at worst case events, then calculating expected values based on the most likely probabilities. Especially after such a huge run in stocks and with the “buy the dippers” still pounding the table.
Still Expensive
If stocks were in the tank and you could not give them away, we would be looking for green shoots to justify upping investment positions. That is a long way off, in our opinion. Trading decisions are a different story, however.
Just take a look at the monthly S&P chart. It looks like we are in a speed wobble in a topping and overbought market which could easily flip us over the handlebars.
China Will Target The Stock Market
In addition to the nuclear option of using its portfolio of U.S. Treasury securities to retaliate against trade tariffs, we believe the Chinese government could target the U.S. stock market.
We wrote last week how the U.S. is in a weaker negotiating position as the result of increased market volatility.
Here is the Washington Post quoting the China Daily, the government newspaper.
“China’s response should follow the principle of a precision strike,” Mei Xinyu, a researcher at a Commerce Ministry think tank wrote in an opinion piece for China Daily. “China should first take measures to deal a blow to the industries in U.S. states that helped Trump win the 2016 presidential election and those states whose political leaders are still backing him in this year’s midterm election.”
But, Mei also recommended selling U.S. Treasury bonds and undermining the U.S. stock market to make Trump “feel the pain.” – Washington Post
Feel the pain, indeed.
Target Apple
What more efficient way to take the U.S stock market down than to hit its largest stock by threatening market access to the Chinese consumer? Apple’s market cap is over $800 billion, the world’s largest, and such a scenario would certainly take the overall market down.
The following chart illustrates Apple derives around $50 billion of its annual revenues from greater China, which is about 20-25 percent of its total revenues.
Furthermore, Apple assembles most of its iPhones and gadgets in China. A disruption to Apple’s supply chain would further disrupt the stock.
U.S. iPhone Imports Distort Trade Imbalance With China
We have not heard much about it during the recent uptick in trade rhetoric, but U.S. consumption of iPhones distorts the China-U.S. Trade imbalance. China primarily assembles the iPhone, which accounts for only about 3-6 percent of its value added, yet the full value of iPhones are counted in the bilateral trade numbers.
Take a look at the iPhone X. IHS Markit estimates its components cost a total of $370.25. Of that, $110 goes to Samsung Electronics in South Korea for supplying displays. Another $44.45 goes to Japan’s Toshiba Corp and South Korea’s SK Hynix for memory chips.
Other suppliers from Taiwan, the US and Europe also take their portion, while assembly, done by contract manufacturers in China like Foxconn, represents only an estimated three to six percent of the manufacturing cost.
Current trade statistics, however, count most of the manufacturing cost in China’s export numbers, which has prompted global bodies like the World Trade Organization to consider alternative calculations that include where value is added.
…Apple shipped 61 million iPhones to the US last year, data from researchers Counterpoint and IHS Markit show, spending $258 on average to make each iPhone 7 and 7 Plus.
Using a rough calculation, that implies the iPhone 7 series added $15.7bn to the US trade deficit with China last year, about 4.4 percent of the total. That’s also about 22 percent of the $70bn in mobile phones and household goods the US imported from China. – Al Jazeera
Here is a good illustration and further explanation of calculating trade based on value added rather on a gross basis from the OECD,
It is important to keep the above in perspective. But, hey, it’s politics. Throw out all rationality, no?
Upshot
Stocks are expensive and though cyclical factors remain relatively positive – earnings and growth — we are looking below the surface at potential structural shifts in the macro environment. Movements of the tectonic plates, such as shifts in long-term capital flows, valuation, and sentiment; the erosion of the liberal world economic order; secular political trends, and the long-term trajectory of interest rates, among others.
We give our worst case scenario in the tariff dispute about a 33 percent probability and believe the market has only priced in a 5 percent probability. There is much more going on than just the trade rift between the U.S and China, including growing tensions over Taiwan, the East China Seas, North Korea, and the appointment of John Bolton as the new National Security Adviser. Any or all of these could move south and feedback into trade negotiations blowing up market volatility.
Bigger picture, and more important, is the Thucydides Trap.
Thucydides’s Trap teaches us that on the historical record, war is more likely than not. From Trump’s campaign claims that China is “ripping us off” to recent announcements about his “great chemistry” with Xi, he has accelerated the harrowing roller coaster of U.S.-China relations. If the president and his national security team hope to avoid catastrophic war with China while protecting and advancing American national interests, they must closely study the lessons of the Cold War. – Graham Allison
Stay tuned.
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