- Morgan Stanley strategist Michael Zezas says the US-China trade war will only get worse from here because both sides have reasons to drag the dispute out longer. He's identified three dynamics that will drive the market as the dispute drags on.
- Zezas says more escalation is coming later in the year, which plays into Morgan Stanley's forecast of a correction for stocks.
- He sees the trade war as something that's exacerbating other big problems for stocks and not the cause of them.
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Stocks are tumbling as the US-China trade war grows more intense, and Morgan Stanley says it will only get worse from here.
For more than a year stocks have gyrated as investors reacted to the state of trade talks. But Morgan Stanley's head of US public policy strategy Michael Zezas says investors need to accept that the situation will get worse soon.
"This round of tariffs will likely be put in place, and investors should behave as if further escalation will happen in 2019," he writes.
He notes that both sides believe they have reasons to extend the dispute. Beijing seems to have doubts about whether the US is a reliable negotiating partner. It would rather hold out and wait for a better deal than accept the economic changes and enforcement the Trump administration has called for.
On the other side, he believes the US might decide that it's in the nation's best interest to ramp up the intensity ahead of the 2020 presidential election.
Zezas says that President Trump and his advisors might decide that more aggressive trade policies will encourage more interest rate cuts from the Federal Reserve, helping the economy; that they will be able to "reframe" the argument around the trade war; and that China might give in.
That means it's likely that the next tariffs will take effect as announced and the dispute will get more intense.
"There remains no evidence that any progress has been made on the key sticking points," says Zezas. "If China remains steadfast, the US administration's instinct is to escalate."
Morgan Stanley has consistently been more bearish than many on Wall Street and has been predicting a 10% correction for stocks during the third quarter.
Here's how Zezas believes that will play out for markets:
(1) Slower economic growth
The trade war and the uncertainty it's created have created a "negative feedback loop" that's hammering corporate confidence, according to Zezas.
While investors hope the Federal Reserve's interest rate cuts will limit the damage, he says they can't break that loop. That will cut into business spending and reduce economic growth.
"More tariffs should drag on corporate confidence, capex and global growth in the near term," Zezas says.
One reason is that the US-China dispute is not the only difficult trade situation. Zezas writes that the Trump administration hasn't made much progress in talks with other trade partners either, and uncertainty at the World Trade Organization is also rising.
(2) More dovishness from the Fed
The Fed has focused on confidence as its way of strengthening the economy, Zezas writes. With the trade war getting worse over the last few months, financial conditions have tightened and there are signs that important measurements of confidence have decreased.
As noted, if business confidence is down, companies will spend less and growth will likely fade. The same applies to consumers and their level of confidence - and spending by consumers makes up most of the US economy. Because of the economic effects, Zezas thinks that dynamic will push the Fed to signal more rate cuts.
"If this erosion is sustained, the confidence channel overall will lead the Fed, in our view, to again note heightened downside risks to the outlook and confirm market expectations for additional interest rate cuts," he says.
(3) Trouble for equities and credit
Morgan Stanley has been bearish on stocks and that's sentiment has only grown this quarter. Zezas says the trade dispute is adding to deeper challenges facing stocks and creating a weaker environment for both equities and credit.
"Trade issues act as an accelerant to, not the primary cause of, other cyclical headwinds," Zezas writes.
The larger problem in Morgan Stanley's view its belief that corporate earnings will go into a recession. US strategist and CIO Mike Wilson also names elevated sentiment among investors, rising market volatility, and the growing threat of an economic recession as major threats to stocks, which were at record highs just days ago.
In a separate note to clients written Saturday, Wilson said that the average global stock index has ranged between flat to down 10% in the last 18 months while the S&P 500 has risen in volatile trading. He argues that that's more evidence it has room to fall as challenges mount.