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MR. MICHAEL CEMBALEST:  Good afternoon, this is Michael Cembalest [phonetic] with the May 2019 Eye on the Market podcast.  I do think it is important to highlight four points on this whole China, U.S. trade war.  First, when you put into context what is going on, the Trump administration tariffs here might roll back tariff declines by 20 or 30 years or so.  In other words once you factor in the tariff increases and likely substitution effects this will put U.S. tariff rates back to roughly where they were in the mid 1970’s.  That being said most of the estimates that I am seeing about the impact on U.S. inflation even if the U.S. keeps this new 25 percent tariff on 200 billion on Chinese goods in place is only about a one time increase in inflation by .2 or .3 percent in 2019 or maybe spread into 2020 and at a time when inflation is running at 1.5 to 2 percent by the different measures that everybody looks at that doesn’t sound that terrifying.  And there is a chart on the first page on the Eye on the Market that shows the history of tariffs going back about 100 years. 

 

And where all the different permutations stack up on those, did they leave this tariff in place?  Did they tax the remaining 300 billion of untariff Chinese goods or did they apply tariffs on European and Japanese auto and auto parts imports.  You know, the chart illustrates all the potential permutations.  And the second point I think it is important to keep in mind is even if the economic impacts of tariffs were small the sentiment impacts to investors are pretty bad. 

 

Globalization through my entire career which I joined JPMorgan in the 90’s, 1987 more than anything else globalization has been the factor that has been driving U.S. profit margins higher given its impact on suppressing wage and price inflation and by expanding the universe of revenue opportunities for our S&P companies which has climbed higher and higher every year.  And this is particularly the case for U.S. tech companies.  That is the sector that has the highest percentage of foreign sales.  More than half of all sales of U.S. tech companies comes from outside the U.S.  So I understand the market reaction and their scope for further downside if Trump does ratchet up the trade war even over and above where things stand right now.  And we also have a chart that shows if you look at tariffs relative to GDP or consumer spending they are small but when you look at the specific impact on individual sectors like tech and also industrial capital goods they can be considerably larger as a percentage of earnings. 

 

Now the third point I think is important to keep in mind and I think everybody knows this but I wanted to illustrate it this week with a chart is I have some sympathy for why the administration is pushing back on the Chinese reversals of concessions that they had agreed to make earlier in this whole negotiation process.  Let’s think about something for a minute.  China joined the World Trade Organization in 2001. Afterwards there was an explosion of Chinese exports to the world and massive inflows of foreign directed investment into China.  And yet, here we are 18 years later and China still ranks close the bottom in the entire world, both emerging and developed countries with respect to intellectual property protections, software piracy, forced technology transfer, preferences for domestic companies and things like that and we have a chart that ranks China on this mercantilism index across all these different measures.  And China actually comes in last and so you know, there is a reason that U.S. trade negotiators since the Bush administration have been trying to get China to make concessions on these issues and you know, so far without too much success so I do have sympathy for the administration on that front. 

 

And I do, to reiterate I do think there will be a deal struck sometime this year in which case I would expect you know, a half or more of this recent sell off to reverse itself.  And then the fourth thing I want to point out and the last thing is you might have thought in a year when there is a growing dispute between the United States and China with China being the largest weight in the emerging markets equity index you might have thought a U.S. China trade year, trade dispute year would also be a year in which Japan and Europe would finally collectively outperform U.S. and emerging markets.  And if you thought that you would be wrong again.  So this overweight U.S. and emerging markets equity barbell that I have been writing about forever has outperformed again this year for the 10th year over the last 13.  Now even with the latest bearish results on the trade war valuations were still on the high side of history given the recovery we had in the year and the last time in the market we talked about the fact that we have just witnessed the fastest post bear market recovery in the last 70 years and credit and equity valuations are not that far off last year’s peaks even with this recent sell off.  And one of the reasons for that, you should take a look at this is even with the huge IPO calendar that we have had in the U.S. the U.S. and global equity supply, net equity supply which is impacted by IPO’s that make it grow and other secondary issuance and then buyouts and buybacks and M&A activity which reduce it.  It has been for the last three years global net equity supply, and U.S. net equity supply has been close to zero.  So that is a technical factor that tends to support the market when things would otherwise be weak. 

 

It doesn’t prevent the markets from falling but it does mean that once people start rebalancing there is less equities for there to buy than you might think.  So there are two more topics for this month that I wanted to address with everybody which is first the outlook for prescription drug price legislation and then also a related look at the political ideology of the 2020 presidential candidates.  And I think the two are connected and I don’t think it is a coincidence that drug prescription, drug price controls finally look like something will happen and is happening at the same that you are seeing growing influence of the congressional progressive caucus.  So first on the drug price legislation it has been hard historically to get really good data on just how much more U.S. drug prices are versus other countries because in the U.S. you have a system under which private insurers negotiate directly with drug companies to set the price for a drug.  So that you are going to have multiple prices for the same drug depending upon what insurer or drug company combination you are looking at.  And there are also a lot of rebates and discounts, which can obscure what is actually being paid.  And so there were two studies that were done recently. 

 

One for Medicare Part B and one for Medicare Part D.  Which decomposed all of that and they all came out to the same results which is roughly anywhere from three to four times meaning U.S. drug prices for the same dosage and the same kind of patient and the same everything costs three to four times more in the United States than what it does in other developed countries.  And so that is the kind of thing that is helping to galvanize support for something being done in Congress.  What is interesting is that our contacts in D.C. tell us that with the departure of some senior democrats who are not in favor of drug price legislation and with a couple of GOP senators ready to break ranks and pass something this might actually get done before the 2020 election.  What is interesting is that the Keiser Foundation did a poll and found across all political parties 90 percent plus political support for allowing the federal government to use its leveraging power to negotiate drug prices something, which is legally not allowed to do right now with respect to Medicare Part D. 

 

So we will see what happens and as I mentioned the political wins now show that around a little, almost half of 2018 house primary candidates in the democratic party identified as being progressive a number that was up from 30 percent to 2016.  So just two years the candidates identifying as progressive went from 30 percent to almost 50 percent.  And again, the Congressional progressive caucus with 100 members is the largest one in the Democratic Party.  And so you look at the laundry list of what has been proposed so far taxes on income over 600,000 at rates of 70 percent, financial transactions tax, hike in the corporate tax rate, wealth taxes, bans on stock buybacks, rules that a third of the board see companies have to be chosen by employees, sur taxes on corporate profits, etc., etc.  One of the things we are watching is how these progressive policies are spreading from progressive candidates to liberals and centrists during the primary season.  And so on the last page of this week’s Eye on the Market we updated the chart that shows the political ideology of 2020 candidates relative to the last 100 years or so.  Based on their voting patterns in Congress.  So take a look and you can judge the chart for yourself in terms of what you think about it.  Anyway we will keep you updated as things on the whole China trade war situation change.  Again, we do expect some kind of deal to take place but the risks of a breakdown in talks has definitely risen and we will keep you updated.  Have a good week.

 

VOICE RECORDING:  Michael Cembalest’s Eye on the Market offers a unique perspective on the economy, current events, markets, and investment portfolios and is a production of JPMorgan Asset and Wealth Management.  Michael Cembalest is the chairman of Market and Investment Strategy for JPMorgan Asset Management and is one of our most renowned and provocative speakers.  For more information please subscribe to the Eye on the Market by contacting your JPMorgan representative.  If you would like to hear more please explore episodes on ITunes or on our website.  This podcast is intended for informational purposes only and is a communication on behalf of JPMorgan Institutional Investments, Incorporated.  Views may not be suitable for all investors and are not intended as personal investment advice or as a solicitation or recommendation. Outlooks and past performance are never guarantees of future results.  This is not investment research.  Please read other important information which can be found at WWW.JPMORGAN.COM/DISCLAIMER/EOTM.

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I now believe that prospects for a deal are only 50/50 given China’s withdrawal of concessions. The economic impact of a growing tariff conflict on the US is modest, but the hit to earnings could be worse. The negative market reaction is in part a consequence of how high valuations became after the spring 2019 rally. Also, how new research on US prescription drug prices vs other countries affects the prospects for drug price legislation. We conclude with an updated ideological scorecard for 2020 Presidential candidates and their policies.

U.S. tariff history and projections assuming no change in U.S. import demand from targeted foreign exporters

Source: Esteban Ortiz-Ospina and Max Roser "International Trade", US International Trade Commission, USITC, US Census, JPMAM. May 2019.
The chart shows the US effective tariff rate since 1910 (displayed by a dotted line), and projections assuming new tariffs and no change in US import demand from targeted foreign exporters. The historical effective tariff rate displays a downward trend since the 1930s Smoot-Hawley Tariff Act peak. The dots show the estimated cumulative impacts of each new tariff on effective tariff rates. The first dot shows the effective tariff rate after tariffs were imposed on washing machines, solar, steel and aluminum. The second dot shows the effective tariff rate after 25% tariffs were imposed on US$50bn of Chinese imports. The third dot shows the effective tariff rate after 10% tariffs were imposed on US$200bn of Chinese imports. The fourth dot shows the effective tariff rate after 25% tariffs were imposed on the original US$200bn of Chinese imports. The fifth dot shows the potential effective tariff rate if 25% tariffs were to be imposed on an additional US$290bn of Chinese imports. The sixth dot shows the potential effective tariff rate if 25% tariffs were to be imposed on auto/parts imports. The current tariffs implemented (dot 4) have taken the effective tariff rate back to 1970s levels. The sixth dot would take the effective tariff rate back to 1940s levels.

Points of dispute in the U.S.-China trade war

Source: OECD, BSA, GIPC, ITIF, Fraser Institute, JPMAM. 2019.
The chart shows the points of dispute in the US-China trade war and China's rank vs developed and emerging economies. The chart displays China’s rank in: protection of trade secrets and data, IP enforcement (civil/criminal penalties, transparency, fines), extent of pirated software, barriers to market access and forced technology transfer, copyright protections, injunctive relief, anti-piracy rules, receptivity to FDI, the ITIF “Mercantilism Index” (forced local production in exchange for market access, export subsidies, IP theft, favoritism of domestic companies, FX manipulation), state control of the private sector (scope and magnitude of SOEs, price controls). China is ranked at the bottom on State control of the private sector and on the ITIF Mercantilism Index and close to the bottom in the remaining categories.