Three significant issues for the next few months are:
- Whether the Fed will tighten for the fourth time this year at the Federal Open Market Committee (FOMC) meeting, and how hawkish it sounds
- How aggressively President Trump pursues his trade war agenda
- The amount that China will invest to stimulate its economy. $175 billion has been approved
A December Fed funds rate hike is looking likely with increased pressure on wages. More important will be the message that investors take from the FOMC statement. Markets are pricing in additional tightening with more interest rate increase(s) in 2018 and a further three or four hikes in 2019. This would take the federal funds rate to 3.3%. A shift to a more aggressive outlook would put upward pressure on the U.S. dollar and Treasury yields. It also would add to the stresses in emerging markets. We think the risks are shifting towards a slightly more aggressive Fed than the market is pricing. President Trump has implemented a further $200 billion in tariffs against China at a 10% rate. He has threatened to increase this to a 25% rate and further threatened tariffs on an additional $267 billion, which would cover the entirety of China’s exports to the U.S. He has also threatened tariffs against Europe’s automobile industry, although these seem less likely to be implemented. We see an escalation in trade wars as a threat to emerging markets and global trade. Meanwhile, Chinese President Xi Jinping is focused on deleveraging and structural reform in China, but he also needs to implement policy stimulus to counteract the impact of U.S. tariffs. Some stimulus has already happened, most notably the 9% depreciation in the renminbi since April. More stimulus is coming in a mix of fiscal spending and credit easing. It is unlikely, however, to be close to the substantial easing that took place in 2009 and 2015. We believe it is more likely to resemble “stepping off the brake” than “pushing on the accelerator”.
Vehicle owners are likely to start paying more for brake components, tires, windshield wipers and mirrors as businesses in the replacement parts industry — from component makers to maintenance shops — scramble to cope with President Trump’s tariffs on imported Chinese materials and goods. Steep levies have already boosted costs of some products made with steel and aluminum, and more duties could affect hundreds of other items these companies develop, make and sell. Suppliers are adding a fractional part of the tariffs onto costs and a few more will do so early in the fourth quarter. So far, they have been able to pass that along to customers. If the proposed tariffs on the additional $200 billion are enacted, prices will rise on at least 3,000 more of its products, which include metal parts, tires, oil and fuel filters and components for towing systems. Vehicle owners are going to have to pay that extra cost in the end. The fallout from tariffs for aftermarket suppliers would likely be relatively muted and felt more over the long term, particularly given that sector mostly serves owners of vehicles rather than buyers of new vehicles. Moreover, higher prices on imported vehicles may prompt some consumers to hold on to their existing vehicles, potentially offsetting the negative impact of tariffs by increasing demand for replacement parts. Tariffs on replacement parts imports would have little direct impact on US sales of aftermarket parts, as most of these products for domestic cars are manufactured domestically.
The effect on individual suppliers will depend largely on how much they rely on sales to original equipment (OE) makers. Other factors include suppliers’ relative exposure to the vehicle market, the proportion of revenue they derive from sales to domestic vehicle manufacturers, the strength of their own online retail presence, and how much of their production is based in Canada or Mexico. Another consideration that will affect the relative impact from prospective tariffs is that rated aftermarket parts suppliers service consumers at different stages of a vehicle’s life. As a result, the near-term implications of import tariffs will be determined in part by the relevant stage of their respective service. There is also the risk that oil prices could head higher as global supply is restricted by the renewed U.S. sanctions against Iran, the economic collapse in Venezuela and the growing risks of a civil war in Iraq.
Emerging markets look oversold as the third quarter ends, though still offer reasonable value, but we believe the risks of an escalated trade war and a stronger U.S. dollar (USD) on the back of a more hawkish Fed argue for caution for now. We also like the idea of leaning into Eurozone equity exposure after its recent underperformance. Italian risk looks to be dissipating, corporate earnings remain robust and the industry consensus has become too pessimistic about the economic outlook. Trade-war risk, however, tempers our enthusiasm. Our observation indicates that US has been able to obtain some concessions and acknowledgement from European countries and members of NAFTA. The biggest hurdle is still China as the two economic superpowers know the stake is high. China has fought the war strongly but is signaling more willingness recently. China is also buying time because the current circumstances such as upcoming November elections in the US may make a difference for them. They may gamble to delay because a change in the Congressional power may give them more negotiating opportunity. Settling with China is major hurdle which is long drawn and there is a lot at stake for both superpowers. Ultimately each side will win some and lose some by compromising. Currently, Chinese economic pressure to settle is greater than the US but it is prolonged, and the settlement needs to be in negotiated. There are no winners or losers, because both economies will get weaker if the end is not reached.