On Monday, August 24, 2015, the stock market was in chaos.
The Dow Jones Industrial Average plummeted 1,068 points—its largest intraday point drop ever at the time.
The Russell 3000 index witnessed 765 stocks fall over 10%.
Exchanges halted trading on 1,278 exchange-traded funds (ETFs) and stocks.
That was in the first five minutes of trading…
U.S. markets recovered some of their losses later in the day—finishing down “only” 3% after the initial correction… However, another double-digit decline followed just five months later.
So who was responsible for the initial massive volatility on August 24, 2015?
China.
Today, as the trade war between China and the United States escalates, the Middle Kingdom could unleash its most potent financial weapon—and cause another wave of volatility like it did in 2015.
I’ll tell you what this weapon is and—more importantly—how to prepare for it. But first, let’s update our conversation about the trade war…
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Trade War Is On
As we’ve shown you in previous issues of the Daily, each major turning point in the market over the past few months has corresponded to President Trump’s trade war rhetoric.
When the market rallies, Trump gets tough on trade. When the market falls, Trump softens his stance.
Last week, the president ratcheted up his rhetoric again… threatening to place 10% tariffs on $200 billion worth of Chinese goods.
Trump was retaliating after China threatened to impose tariffs on U.S. goods. (China’s threat was a response to Trump’s initial round of tariffs against Chinese products.)
With the language heating up again, the large-cap S&P 500 index is down 3%.
Here’s the thing…
Even though the trade war is rattling U.S. markets, China realizes that it can’t win simply by issuing tit-for-tat tariffs against the United States.
It must do something bigger.
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China’s Options
China has three main options to hit back against the United States.
The first would be to dump its U.S. bonds.
China owns $1.2 trillion worth of U.S. Treasuries. And it could stick it to the U.S. by selling them.
The consensus is that if China did dump Treasury notes, U.S. interest rates would skyrocket. And rising rates would destabilize the U.S. economy.
I doubt China will choose this option, though. It would be shooting itself in the foot. A Treasury note dump would cause its holdings to lose a lot of value.
Plus, China would have nowhere else to reinvest that much capital. There aren’t any other safe places to handle a $1.2 trillion inflow.
China’s second option would be to impose tariffs on U.S. companies that manufacture and sell stuff within China.
Contrary to what most people believe, the U.S. has a trade surplus with China (if you add U.S. exports to China and the sales of U.S. companies in China).
However, Chinese President Xi Jinping has signaled that he doesn’t want to use this option either. He’s worried that penalizing U.S. companies operating in China would jeopardize foreign investment from other countries.
He’s right.
Foreign companies won’t invest in China if they think the Chinese government might take punitive measures against them because of actions by their home governments.
So that leaves China with only one, final option in the trade war. And it could disrupt the financial markets this summer.
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China’s Nuclear Option
China’s third option is the same weapon that it used to cause volatility in August 2015: devaluing its currency.
When China devalues the yuan, its exports to the U.S. become cheaper. With cheaper products, Chinese companies can undercut the prices of U.S. companies.
China did this twice in 2015… Each time, the U.S. market panicked.
The black line shows the dollar versus the yuan. The blue line shows the S&P 500. When the black line goes up, that means the dollar is strengthening against the yuan.
As you can see, when China devalued the yuan in August 2015, U.S. markets had a violent sell-off two weeks later.
China also devalued (although at a slightly slower pace) the yuan at the end of 2015. That led to the U.S. sell-off in January 2016.
Eventually, the market adjusted to the devaluation. But it took two double-digit declines before it did so.
However, since 2016, the market has gotten accustomed to a strengthening yuan. A stronger yuan gives U.S. companies a cost advantage because U.S. goods are cheaper to buy relative to Chinese goods.
In 2017, the yuan strengthened 10% against the dollar. But that’s changing…
As you can see in the chart above, the yuan has been weakening since last April.
China’s Nuclear Option Is Locked and Loaded
We’re not sure what’s causing the yuan to weaken right now. It could be losing strength due to the trade war. Or the Chinese central bank could be behind it.
What we do know is that the yuan is falling. And if it continues to do that, the U.S. market will see more volatility.
(On Tuesday, the Chinese central bank said it would support the yuan to prevent it from weakening further. I don’t believe it… I think it’s a half-hearted effort to provide a little short-term strength while the yuan continues falling.)
Expect more volatility as trade war rhetoric escalates… But it will most likely be temporary—just as it was in 2015.
We’re still in a bull market and you want to own stocks—especially small-cap stocks like those in the iShares Russell 2000 ETF (IWM).
These types of companies do most of their business in the United States, so they’re more insulated from a trade war than large multinationals.
If the volatility scares you a little, consider holding some cash or gold as well while you wait for this to play out.
Regards,
Nick Rokke, CFA
Analyst, The Palm Beach Daily
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