With US traders still blissfully ignoring the consequences of escalating trade war between the US and China, which has yet to make any material dent on either the US economy or S&P500 corporate profits, prominent sellside banks have increasingly taken to issuing louder warnings about how they see said conflict progressing. Late last week, JPMorgan became the latest to drastically revise it outlook, and in a note from strategist John Normand writes that the bank has "adopted a new baseline that assumes a US-China endgame involving 25% US tariffs on all Chinese goods in 2019."
As a reminder of how methodically the US has been advancing a campaign some consider "random and capricious", Normand summarizes the current state of affairs, noting that Phase I involved tariffs on $50bn of Chinese imports in July and August; Phase II levied 10% tariffs on $200bn of imports in late September that rise to 25% in January; and Phase III is the threat to impose 25% taxes on another $267bn of imports at some stage.
It is now JPM's baseline view that the US and China will not resolve their differences this year and that the Administration will make good on its threats to escalate.
As a result of this full-blown trade war escalation, JPM has revised its China-related forecasts, expecting only a modest hit to Chinese growth - thanks to offsetting fiscal and monetary stimulus - however it now sees a far steeper devaluation in the Chinese Yuan relative to Wall Street consensus, one which will impact the rest of the EM space; finally the trade war is still expected to have only a negligible impact on the US economy, resulting in a 0.2% decline in GDP and 0.3% in core inflation. To wit:
- full tariffs would reduce Chinese real GDP growth (currently 6.7% yoy) by 1%, but to offset this authorities will provide additional fiscal stimulus (augmented fiscal deficit rises from -10.8% of GDP in 2018 to -11.3%) & looser monetary policy (3 cuts in reserve requirements versus a previous forecast of 2). These offsets would "almost fully compensate for tariffs" and as a result the bank cuts its 2019 China growth forecast only 0.1%, from 6.2% to 6.1%;
- looser monetary policy and less/no intervention should allow greater CNY depreciation of about 4.5% trade-weighted in the next 12 mths, corresponding to USD/CNY at 7.01 in Dec 2018 and 7.19 in Sep 2019;
- negligible reductions of 0.2% on US growth and 0.3% on core inflation.
As part of this revision, JPM cautions that "looser Chinese monetary policy ensures that the U.S. dollar will become an ever-higher yielder versus the renminbi for the rest of the cycle", as the yield gap will favor the dollar thanks to further Federal Reserve tightening.
The cheaper yuan will also drag emerging Asian nations’ currencies lower with it, as it would be "tough for EM Asian currencies to rally if the renminbi depreciates further." In terms of asset price impacts, these Asian currency declines "are possible constraints on regional equities," JPM predicted, although it does see base metals prices gaining into 2019 thanks to reduced inventories.
What is most actionable for traders as part of the new JPM forecast, is that this new baseline "raises medium-term questions for the world's most-expensive equity market (US) and one of its cheapest (China)." Specifically, JPM's Equity strategists estimate that 25% tariffs on all imports from China could take $8 off consensus 2019 EPS projections of $179 and reduce next year’s EPS growth from 10% to 5% year-on-year
Such a downgrade would mark the first of the Trump era, and potentially end the US stock market rally even assuming a forward multiple of 17, unless some other offset materializes.
In recent weeks, Goldman Sachs has likewise been turning increasingly pessimistic.
In a Friday note from the bank's chief equity strategist David Kostin, Goldman - which assigns a 60% probability the US will impose tariffs on most or all of the additional $267 billion of imports from China that are not covered by the tariffs announced to date - issued a warning that whereas so far S&P profits and margins have been able to avoid a direct hit, this may change soon:
Tariffs represent a threat to corporate earnings through higher costs and lower margins. For all US industry, roughly 15% of cost of goods sold (COGS) is imported. Given S&P 500 constituent firms are more global in nature and have more complex supply chains than overall industry, we estimate imports account for roughly 30% of S&P 500 COGS. This estimate is consistent with the 30% share of S&P 500 sales generated outside the US. Imports from China account for 18% of total US imports.
In the context of rising threats to US profitability, Kostin recommends shifting portfolios into companies that have "high and stable" profit margins and substantial pricing power to outlast the upcoming trade war escalation. Meanwhile, even as Goldman does not predict a severe impact to either the market or stocks, Kostin repeats an analysis he made three weeks ago, warning that if trade tensions spread significantly and a 10% tariff were implemented on all US imports - the highest rate since 1940s - the bank's EPS estimate could fall by 15% to $145 in the "severe case", resulting in a bear market for equities.
Finally, late last week Barclays also opined on how it sees the worst case scenario for US-China trade relations developing, however unlike JPM or Goldman, the UK bank maintained a relatively optimistic outlook. In its quantification of the scenario which now serves as JPM's baseline, Barclays reassured investors writing that "we estimate that a 25% tariff on all US-China trade would result in a 3% decline in 2018E earnings, which appears insignificant, given our projected growth of 23% for 2018.”
Barclays may be behind the curve: in a potential red flag, last week we reported that as companies head into the end of the third quarter, 98 S&P 500 companies have issued EPS guidance for the quarter. Of these 98 companies, 74 have issued negative EPS guidance and 24 companies have issued positive EPS guidance.
The percentage of companies issuing negative EPS guidance is 76% (74 out of 98), which is not only above the five-year average of 71%, but if 76% is the final percentage for the quarter, it will mark the highest percentage of S&P 500 companies issuing negative EPS guidance for a quarter since Q1 2016 (79%).
Much of this shift in sentiment is the result of growing tariff fears. And now that "phase II" in the China trade war has been launched, and a "phase III" - tariffs on all China imports - appears imminent, the corporate outlook picture - the key driver behind the S&P's remarkable resilience - will become increasingly more problematic.