Market shocks often erupt after a long period of slowly heating up, otherwise known as the boiling frog syndrome. The mortgage and credit excesses were simmering back in 2005, for instance, only for investors to stay focused on squeezing markets for a little extra return.
For more than a year the deteriorating broad economic and political relationship between the US and China has provided plenty of action for investors. Tariff hikes have been exchanged and while markets have certainly not enjoyed these bouts of slightly higher temperatures, the ensuing dips in shares and credit have been limited and bought.
Investors still take comfort in the general view that neither the US nor China wants to break the global economy and trigger a resoundingly negative market reaction. They are also keeping the faith that China will maintain its economic stimulus, and that major central banks will keep juicing up the financial system, including corporate earnings, until the second half of the year.
This week’s burst of share market selling should be viewed in the context that in broad terms, the MSCI All World equity index has only slipped 4.5 per cent from its late April high and remains about 10 per cent firmer in the year so far.
But during the past 12 months, marked by the steady rise of trade tension between the big two, the MSCI World index has gone sideways, with defensive sectors outperforming, a trend that has only strengthened this month.
The flip side of this rotation has been pressure on emerging markets and trade sensitive sectors, with global chipmakers for example, nursing a hefty double-digit loss during May. By that measure, the frog is getting hot.
This represents an indicator that as China and the US turn up the tough talk on trade, the gloves may truly come off and at a vulnerable time for the global economy.
The US and other countries have long and rightfully singled out China’s flouting of trade agreements and theft of intellectual property from companies. Moving from applying tariffs to blocking China’s technology via Huawei and other companies does represent a troubling long-term shift for financial markets.
Investors face the prospect of companies that have enjoyed the benefits of global supply chains and squeezing the best out of technological progress, may have to radically alter their business models. While hopefully a short-term disruption, that entails a weaker pace of earnings growth and at a time when the business cycle has entered a delicate period, buffeted by rising costs such as wages.
Andrew Milligan, head of global strategy at Aberdeen Standard Investments says there is a growing likelihood that investors face a world where “a higher political premium must be priced into the outlook for corporate earnings”.
Hardly helping this situation would be a pronounced shift towards separate Chinese and US technology standards, along with both countries pushing national champions, resulting in the duplication of research efforts that inserts more barriers across the global economy.
Sitting uncomfortably in the middle of this are US allies, including the likes of Europe, the UK, Japan, South Korea, Canada and Australia, along with their big multinational companies. Here investors should recognise that a template already exists for how challenging this type of world could become. The Department of Justice in recent years has gone after foreign banks for trading with countries like Iran within a global financial system dominated by the US dollar.
Alan Ruskin at Deutsche Bank poses a pertinent question for anyone who thinks and has invested across markets with the idea that China and the US will eventually resolve their differences or at least find some common ground.
“In the coming decade will China’s military operate on US software, and will the US’s military operate on ‘made in China’ hardware?”
Banning Huawei may be just another bargaining chip for the White House trade hawks. Indeed, President Trump on Thursday suggested that the Chinese telecommunications network company could be part of trade deal.
Under that scenario, the reluctance of equity markets to really hit the panic button will be vindicated and investors can return to gauging whether a firmer global economy later this year helps extend the current business cycle.
Clearly, the G20 meeting in late June marks a key moment for investors, or as Mr Ruskin says, “not in delivering an overarching deal, but in revealing how much President Trump is willing to walk back measures on Huawei after meeting President Xi”.
Investors are already trying to figure out the long-term impacts of climate change, the shift towards alternative energy sources, the rise of artificial intelligence, increasing use of robots and the sharing economy.
A hardening of the geopolitical battle lines over technology means that even more deep thinking about their portfolio exposure is required.