Against the odds, the U.S.-China trade war has escalated. This is bad news for companies and industries with significant exposure to China, like Apple and semiconductors. It’s a positive for areas of the market that benefit from currency wars and interest rate cuts, like gold and gold stocks.

To briefly summarize, it appeared the trade talks were headed toward a resolution. But then the United States accused China of backtracking and issued new tariff threats and ultimatums. China responded with its own hard line, digging in its heels and raising tariffs on $60 billion worth of U.S. goods. If tensions continue to rise, $740 billion worth of goods could be impacted.

Wall Street was not expecting this. Most industries and sectors were priced for the favorable scenario, in which the trade war bluster subsided and a friendly deal was worked out.

But if a scenario has a 70-80% chance of success, that still means a 20-30% chance of failure. In Texas Hold ‘Em, not even pocket Aces are a sure thing. Complicated trade agreements are the same.

It’s still possible that a U.S.-China trade deal could go through. But the likelihood has fallen sharply. Rhetoric on both sides has sharpened, with China declaring the trade conflict a “people’s war” in local press.

There is now a significantly increased chance the tariffs could expand in size and last for years, and that the fall-out could land in unpredictable ways. Wall Street is worried about this. It’s not about the short-term cost of the tariffs so much as the long-term impacts and tipping point dangers.

For example, some of America’s most beloved and profitable companies, like Apple, make significant profits in China, and close to half of S&P 500 earnings are generated overseas. Meanwhile, China by itself represents about a third of global economic growth, and tapping into China’s domestic economy is a big opportunity for many U.S.-listed companies. A prolonged trade war threatens that access.

A trade war also means heightened risk of a China-fueled financial crisis. China’s economy was already slowing prior to the increased trade war tensions, and China has long been saddled with eye-bulging levels of debt. China also has a dangerous real estate bubble fueled by its own version of subprime lending: Trillions of dollars in off-balance-sheet lending tools called WMPs, or Wealth Management Products. Economic pressure could be the pin that makes that bubble pop.

If China is tipped into crisis mode, there will be ripple effects throughout the entire global economy. And the United States economy will not be spared if this happens. For example: In a crisis, China might have to sell off a portion of its $1.1 trillion worth of U.S. treasury bonds to support its currency. That could send a shock wave through the global financial system. Central banks everywhere, including the Federal Reserve, would likely fall back into emergency stimulus mode.

Wall Street’s level of concern is not a matter of opinion. We can see it in the numbers. When China announced retaliatory tariffs, global stock markets lost $1 trillion worth of market cap in a day.

Again, this is not about the dollar size of tariff amounts, which are relatively small. It is about corporate profit projections and lost business opportunities over the course of years or even decades, with near-term tipping point impacts that could put the global economy in a tailspin.

Putting the stock market aside for a moment, interest rate forecasts are the real “tell” for Wall Street’s level of concern here. Federal-funds futures contracts, which indicate the future direction of interest rates, now forecast more than 70% odds of an interest rate cut, rather than a hike, by the end of 2019, with a non-trivial possibility of multiple cuts. Those odds spiked on the China retaliation announcement.

The CME Group also has something called the CME Fedwatch Tool, which you can check out here. As of this writing, for the January 2020 Fed meeting — about nine months away — there is a 74% expectation the Fed rate will be 50 to 75 basis points lower than it is today.

Those forecasts are remarkable for two reasons. First, the Federal Reserve has not cut interest rates since the 2008 financial crisis. Second, in a healthy and growing economy with unemployment at a 49-year-low, interest rates should logically be moving higher, not lower.

It’s an indication that markets are very worried about something, and other indicators back it up. For example, the yield curve, as represented by the three-month treasury bill yield versus the 10-year yield, went back to negative in the past few days.

Germany’s 10-year bund yield, which is Europe’s version of the U.S. 10-year, has also returned to negative territory and fallen to its lowest level in three years.

These are all warning signs for the health of the global economy, and the escalation of trade war tensions has sent those warnings into overdrive.

As mentioned, if trade war tensions don’t subside — and it is hard to see how they ratchet down from here — that is bad for dynamic companies like Apple, and bad for dynamic U.S. industries like semiconductors.

Basically, any company with a good shot at tapping the powerhouse growth of China’s domestic economy previously had that advantage priced into its profit outlook; now, that threatened advantage is at risk of being priced out. Other companies and industries that benefit from global growth and access to China’s domestic markets — like FedEx, Caterpillar, and Boeing — could also be in trouble.

In a world where interest rates are falling as the global economy sputters, the primary winners could be gold and gold stocks. That is because falling rates and sputtering economies ultimately mean new rounds of central bank stimulus and the stealth monetization of government debt, which in turn means currency debasement and inflation fears.

Gold stocks haven’t done much in 2019, despite a strong start to the year. That was in part due to trade deal optimism and a positive outlook for global economic growth driving investor sentiment. When economies are growing and corporate profits are flowing, gold stocks tend to be ignored.

But the sharp turn of fortunes for the U.S.-China trade war, in which the odds of a deal have fallen and the odds of prolonged pain have risen, are creating a “reset” of Wall Street expectations. That reset, which puts more emphasis on falling interest rates and rising growth fears, is a good one for gold stocks.

Below, you can see a selection of green zone gold stocks from GDXJ, the junior gold miners ETF.

green zone gold stocks from GDXJ

You can also find more precious-metals-related ideas, and other company and industry picks that benefit from a falling interest rate environment, in TradeStops and Ideas by TradeSmith.


Founder, TradeSmith