A "Record Divergence": Why The Market Thinks The US Is The Absolute Trade War Winner

One of the fascinating things about the US stock market has been the resilience with which US stocks have decoupled from the troubles in the rest of the world, and more specifically, how tech stocks have continued to plow higher regardless of newsflow, even as most markets around the globe have slumped deep into correction territory.

To be sure, a big part of that has been the tech sector's stellar margin expansion as discussed earlier...

... yet even so, the relentless and recurring "buy the dip" action observed in US tech stocks has amazed many pundits, and at times even the bulls have been impressed by the sector's unprecedented resilience.

The same can not be said for tech stocks in emerging markets, and especially China.

Indeed, as Credit Suisse remarks in a recent note, while concerns around Turkey have been held up as the primary reason for emerging market underperformance, one shouldn't forget the significant role played by the sharp decline in the EM tech sector, especially after the recent collapse in Tencent stock and more recently, the sharp drop in JD.com following poor earnings. Since the start of June, the EM tech sector has accounted for c.40% of the decline in the value of EM equities, with the Chinese internet names the primary drivers following recent regulatory challenges and poor results. And, as the chart below highlights, this has opened up a record divergence in tech performance between the US and EM.

Needless to say, such a divergence is unusual: in the 18 months to the end of June this year, both the US and EM tech sectors rose by 50% in USD terms. Since then, the EM tech sector is down 6%, while its US counterpart up by 5%.

This is bad news for EM bulls, because looking ahead, with the top 5 stocks in EM all tech names, a stabilization in EM tech is a necessary condition of broader EM outperformance. And, as a reminder to US investors, the decline in EM tech also highlights once again the substantial challenges regulation can pose to this sector. However, as noted above, US tech investors continue to appear sanguine about both regulation and protectionism, but the recent experience of EM tech does highlight the risks.

However, looking at the bigger picture, it's not only the tech sector where divergence is apparent: US protectionism has simply driven a performance wedge between US and non-US assets, as shown in the chart below.

Since the end of the first quarter, the S&P 500 is up 9% and the trade weighted USD by 6%; over the same period MSCI EM is down 12.5%, European banks by 10%, the euro by 8% and copper by 14%. According to Credit Suisse, "this sort of market polarization seems premised on a view that the US will be the one relative, and even absolute, winner in a trade war."

However, as always happens when the market is convinced of something, the opposite tends to happen and in this case, the challenge to this conventionally accepted view is that US macro surprises have now turned negative...

... USD strength will at the margin negatively impact export demand and concern about tariffs is now appearing in US corporate surveys: the word tariff appeared 6 times in the last ISM non-manufacturing release, which saw new orders decline by 6 points.

So what about China, and how is it responding to the US "absolute victory" in the trade war? 

Well, as Credit Suisse notes, the recent RMB weakness should be seen through the lens of protectionism: the initial phase of US tariffs (25% on $50bn of Chinese imports, 10% on a further $200bn) would lift the total cost of Chinese imports to the US by $32.5bn, or 6.5% of total US imports from China (of $500bn). The more aggressive tariff proposal, with 25% applied on $250bn of imports, would lift the cost by 12.5%. The 10% decline in the RMB has therefore more than offset the impact of the initial tariffs, and has even offset the bulk of the impact of the more comprehensive approach – as shown in the fourth chart below.

More broadly, the current period of RMB weakness has not been accompanied by any sense of a loss of policy control by the Chinese government, as the 2015-16 period was: FX reserves have increased in the last 2 months for example. In fact, in offsetting the impact of US tariffs, the period of RMB weakness is arguably meeting Chinese policy objectives, not defying them.

In other words, yes - the market may believe that the US is winning the trade war, but all that China is doing - at least for now - is buying itself time until the US fiscal stimulus boost fades and then it will flip the table on Trump. Meanwhile, aside from some weakness in the stock market and EM tech stocks, the bulk of the US trade war onslaught has been largely offset by China's currency devaluation.