Clear (And Long-Term) Present Danger

The market staged an impressive rally midway through last Friday’s session, but it was the toughest week of the year. Interestingly, lost in the mix was the continued shift into blue-chip names and out of momentum names, mostly on the NASDAQ. Thus, 101 stocks on the NASDAQ landed at 52-week lows – the largest number in 2019. Mostly, this reflects missed earnings or poor guidance, and angst about exposure to the China trade battle.

Clear (and long-term) Present Danger

President Trump has upped the ante in the battle against unfair China trade policies, and the rampant theft of American expertise that tallies hundreds of billions of dollars annually in the tech sector after hollowing out factories for decades with unfair subsidies (against the World Trade Organization (WTO) rules) and the value-added (VAT) tax gimmicks (against WTO rules). 

The issue(s) go well beyond economics, as this technology is being used to build military weapons and capabilities that edge closer to challenging America’s military preeminence. Sadly, this has all happened in plain sight, and America’s efforts to get China to play by the rules have failed repeatedly. It’s unfortunate that those who had opportunities to make this right are among the loudest critics of this administration’s efforts.

Each year, the White House sends a report to Congress on the status of U.S.-China relationships. Below are excerpts from the last report from President Obama to Congress.

EXECUTIVE SUMMARY: The 2016 Annual Report to Congress of the U.S.-China Economic and Security Review Commission

Beijing’s ongoing failure to uphold its World Trade Organization (WTO) commitments, ineffective efforts to cut industrial overcapacity, and unfair treatment of U.S. companies are straining the bilateral relationship.

China appears to be conducting a campaign of commercial espionage against U.S. companies involving a combination of cyber espionage and human infiltration to systematically penetrate the information systems of U.S. companies to steal their intellectual property, devalue them, and acquire them at dramatically reduced prices.

Recommended

There Was a Vile, Violent Attack in Chicago, and the Media's Been Silent. We Know Why. Guy Benson

Advertisement

The U.S. government’s efforts to address tensions in the U.S.- China relationship continue to yield only limited results. At the final round of the Strategic and Economic Dialogue talks under the Obama Administration, participants failed to achieve any major breakthroughs but left with some deliverables on financial sector cooperation.

Excerpts from EXECUTIVE SUMMARY 2009 to Congress:

China continues to use trade-distorting measures in violation of its WTO commitments. The WTO found that China failed to comply with its obligations in terms of enforcement of intellectual property rights laws and to provide sufficient market access to intellectual property rights-related products.

China’s economic reforms were not based on traditional free market principles.

Beijing’s ongoing failure to uphold its World Trade Organization (WTO) commitments, ineffective efforts to cut industrial overcapacity, and unfair treatment of U.S. companies are straining the bilateral relationship.

China appears to be conducting a campaign of commercial espionage against U.S. companies involving a combination of cyber espionage and human infiltration to systematically penetrate the information systems of U.S. companies to steal their intellectual property, devalue them, and acquire them at dramatically reduced prices.

Prisoner’s Dilemma

Many commentators have taken to calling the showdown with China a form of game theory, pointing to the so-called Prisoner’s Dilemma. Essentially, it’s an evolution of options and outcomes that challenge and often get rational people to take irrational actions.

There are lots of diagrams used to explain this form of game theory. However, the one I think best fits the current situation shows where both parties can either be rewarded or be punished.

Choices

• C – cooperation
• D – defect

Outcomes

• R – reward
• P – punishment
• T – temptation
• S – Sucker

Perhaps the notion of ‘saving face’ adds additional elements to these outcomes, although I think it’s more of a motivating factor that will be properly placed in the decision-making process rather than the desired outcome for President Xi.

I understand from China’s vantage point how the arrival of the British in China and the subsequent events from the Opium Wars and the Boxer Rebellion are still motivating the country, and it all plays a role in policies. The outcome of this battle would curb those grand ambitions. 

This battle can get worse. Currently, China is leveling higher tariffs on 92% of U.S. exports to China, whereas the United States is leveling higher tariffs on 46% of Chinese exports into America. 

There is a Risk-Rewards (R/R) outcome available, but the clock is ticking.

Portfolio Approach

I continue to champ at the bit because of great fundamentals. I also continue to acknowledge the downside risk, mostly from emotional selling. Thus far, cooler heads have prevailed, although many in the financial media have worked vigorously to trigger mass selling.

All I can say for the moment is to be cool and don’t panic.

Today’s Session

Equity futures are under pressure as the Trade War shifts into higher gear.   China announced it will implement 25% tariffs on 5,000 U.S. products worth $60.0 billion beginning on June 1^st.

Obviously, we aren’t buying into the start of the session, but this will be another great test for the market to see how eager sideline money wants to get into the mix.  Watch 50-day moving average for S&P 500 and NASDAQ, especially on closing basis. 

Don’t get too cute with knee-jerk moves and panic.  Already, I’m seeing certain names with greater China exposure taking bigger hits, but investors have to consider what names they want in their 401K's and long-term portfolios a year or five from now.

Below is a copy of  a new service from Wall Street Strategies, called "Payne's Perspective/"  This is a weekly publication.  To find out more, call your account rep or email us at info@wstreet.co,. 

Payne's Perspective: It's War

After China returned a 150-page outline of previously agreed upon items with completely different terms, President Trump fired off several angry tweets.  More than shots across the bow, these tweets were a declaration, and reminder, there was a new sheriff in town.

There is much speculation as to why Chinese officials tried such a last-minute underhanded move, including a hunch by the Wall Street Journal that China saw Trump’s tweets regarding the Federal Reserve as a sign of economic weakness. 

I do not buy that, as I’m sure China understands how strong the U.S. economy is, just as U.S. officials understand how weak and vulnerable the Chinese economy has become.  There could have been a guess that the White House was eager for a “win” heading into the election and would simply accept any changes in terms.

I think it was going to happen. as China took a shot and it backfired – big time.

How We Got Here

The developed world welcomed China into the World Trade Organization in December 2001 thinking it would make the nation become an honest player in global commerce.  It would sell its products to the world, and in turn the world would sell its products into China.  There were good reasons to think this would be a great deal, and China would be a great partner, including the fact the country had brought its average MFN (most favored nation) tariffs down to 15.9% from 42.1% in 1992.

China’s tariffs did come down, but they were still prohibitively difficult for nations looking to do business, especially when coupled with local regulations and corruption costs.  Moreover, China’s MFN tariffs began to turn higher.

Grand Theft & Ambitions

Beyond unfair trade and subsidizing industries that crushed American manufacturers, China’s ambitions grew from regional powerhouse to global domination.  These ambitions were outlined in the Made in China 2025 manifesto, and in real life with militarized manmade islands in disputed waters of the Pacific.

To get to the top perch in the world, China has been stealing technology, particularly from American business partners but also from universities and the U.S. government.  The annual price tag for this theft is north of $200.0 billion annual. 

The cost could be more if China can pinpoint American nuclear submarines with American technology.

Since China Joined WTO

• U.S. goods imports from China 2018 $539.5 billion +427%
• U.S. service imports from China 2018 $39.5 billion +414%

2018 Top Imports

• $152 billion Electrical Machinery
• $117 billion Machinery
• $35 billion Furniture & Bedding
• $27 billion Toys & Sports Equipment
• $19 billion Plastics
• $4.9 billion Agriculture

The Tariffs will sting Americans, but they won’t all be foisted on the American consumer.  In fact, American businesses should feel patriotic pride in mitigating and taking some of the hit.  While current and future tariffs will not derail our economy, there will be higher cost in certain areas.

Line in the Sand

President Trump drew a line in the sand for higher tariffs on more products. 

Old Tariffs

• 25% on $50 billion of China’s exports
• 10% on $200 billion in China’s exports

New Tariffs

• 25% on $250 billion in China exports

There is a chance 25% tariffs could eventually be applied to all items China exports into the United States.  In the last year, with existing tariffs in place, overall consumer inflation has been tame and even some heavily imported items like apparel have decreased in cost.

There is going to be a lot of chatter from economic experts attempting to scare the public into surrender, suggesting this is “free trade.” Well, all that cash leaving America barely comes back as China FDI, which was a paltry $39.5 billion in 2017, -2.3% from 2016, while the United States FDI in China clocked in at $107.6 billion.

I think there will be a resolution before more tariffs are applied and the market will rejoice; until then, know a lot of stocks are going on sale.  This is what we love, right?  Buy low!