The U.S.-China Relationship, the Fed, and Data Reliability

The U.S.-China Relationship, the Fed, and Data Reliability

Josh Rubin: This is the CPM roundtable, where Thornburg Client Portfolio Managers will discuss topics that are top of mind for investors. My name is Josh Rubin, and I’m joined today by Phil Gronniger and Adam Sparkman. As client portfolio managers, we’re engaged daily with both the investment team and clients, which gives us a unique insight to what’s top of mind.

Today, we’re going to dive into a theme that has been persistent throughout the year, and honestly, top of mind for investors over the last decade, U.S./China relations. We’ll also touch on data reliability and how both investors and corporates can make decisions in the current environment.

Let’s start with something that everyone was talking about several months ago but seems to be more on the backburner recently. And that’s the US-China relationship. What it means for the US economy, what it means for the Chinese economy and anything else.

Phil Gronniger: When we think about the two biggest kids on the block, so to speak, when we think about economies, it was natural that there would be some head butting between the US and China, particularly as it related to trade. And, you know, China’s exports to the US have declined dramatically, actually, over the last 20 years. It used to be about 7% of their GDP, and today it’s only about 3%. It has been put on the back burner because frankly, it seems like neither one wants to come to a solid resolution right now. They keep kicking the can a little further down the road, whether it’s our administration or the Chinese officials, in trying to come to a sensible conclusion that doesn’t really impact the trade too much between the two countries charged with China.

Adam Sparkman: Josh, I think coming into this, you know, everybody thought that China would really be in the crosshairs of Trump’s tariff policy. Do you have any thoughts on maybe why Trump hasn’t pushed China as hard as many thought he would?

Josh Rubin: Overall, I have to acknowledge that I don’t have a source in the White House right now, but one of the things we are seeing, I would think is the administration’s sort of slow walking, the engagement with China by engaging with some of the other trade partners. So, maybe an underappreciated element of China’s exports over the last decade is exports to Vietnam, Cambodia, Mexico and Canada have grown at about twice the rate as China’s exports to the rest of the world and a reason for that is China has really shifted to being more of a supplier of components of things that get sent to the US, rather than assembling everything in the US.

And that’s changed the direct materiality of Chinese exports to the US. But it hasn’t necessarily fully changed how important US consumption is. So, we have seen agreements with Vietnam and Cambodia. We sort of continue to see some jawboning with Mexico and Canada, but overall, it feels like the Trump administration is trying to lock down agreements with both major global trading partners, as well as some of the Chinese relationships or intermediaries before it ultimately goes to China.

The one other thing we know is the Chinese economy, actually, was pretty strong in the first half of this year, largely because so many exports were front loaded as a US companies or a few other countries were looking to get ahead of any tariffs. So that really supported Chinese economic growth. And maybe there’s either on the part of the Chinese government, some feelings of confidence about the health of their economy, even if things get, more strained with the US, or maybe the US government wants to wait it out and sort of let things get back to normal before reengaging with China.

Adam Sparkman: Not necessarily related specifically to the tariff aspect of the US-China relationship, but have you all been surprised with the overall relationship in different areas, whether it’s Trump not banning TikTok? Give me more time there. And then also with Nvidia chips allowing, you know, allowing those to flow into the country after first, signaling that we wouldn’t.

Josh Rubin: The technology relationship is probably underappreciated because when we think about China, certainly there’s this huge amount of gross exports of general merchandise and China’s key import deficiencies or, or import risks are really run energy and semiconductors. Those are the two areas where China has been a net importer, really for its whole history and still today. So there could be some element of creating goodwill or demonstrating to China that we’re not going to push the, you know, total destruction button, which really is how China might feel pending the any tariffs or sanctions on energy or semiconductors.

But also, one thing that’s really impressive is Chinese innovation around semiconductors. And we do hear that leading Chinese semiconductor companies have made a lot of progress on AI chips, as well as some of the other more leading-edge chips. The key, issue for China has been what are called production yields. And so that’s when Taiwan Semiconductor makes a leading edge chips, 98% of those chips might be high quality and ready for use. When a Chinese fab makes those same chips, it might be 70%, but if you have national security interests or strategic interest, maybe you’re okay with a 70% yield instead of a 95% yield. So, you’re not so worried about the economics, but it could also be the US wants to get China chips that maybe slow down some Chinese innovation, or some Chinese attempts at displacing, the US chip makers, which could also be making the Trump administration go a little easier on this area….Maybe a second element that does relate to China, but brings it back to the US is we know, we’re continue to see some data on inflation. We’re seeing data on the general health of the US economy. And, you know, there’s two parts, one in theory, if there’s on shoring of foreign jobs, that should lead to job growth in the US.

Secondly, there’s a question of whether we’re importing inflation. What do you guys think? You know, there’s a little bit of a question of data reliability, but there’s also a question of just how, not just the fed, but companies might make decisions in the current environment.

Philip Gronniger: Sure. When it comes to data reliability, there’s always revisions to data over time. That’s nothing new. And certainly, the administration is not happy with some recent revisions, particularly when it came to the non-farm payroll downward revision that was rather large, 250,000 to May in June. And it’s led to some questions about the efficacy of that data from a longer-term standpoint, we still have strong confidence in government data, whether it’s Bureau of Labor Statistics, Bureau of Economic Analysis. But it is important to continue to, if you will, evaluate, the strength of that data, because we’re making important decisions from either the administration, the Fed, or as investors here at Thornburg. So now it’s important to reflect back and say, is this good data or are we doing it right statistically.

Josh Rubin: Maybe a question, Phil, do you think you know, there’s two ways the data can flow through. For stocks, we generally care about earnings and whether there’s earnings upside. For bonds, we might care about whether the economy is working or weakening more. And there’s you know, downside risk. Did you notice anything in bond markets indicating higher worries for credit quality with the downward revision in jobs?

Phil Gronniger: The bond market seemed to take it in stride for the most part. Naturally, there’s a concern that we’re seeing the slowdown in the economy with revision, but that was already happening. If we look at the year over year change in the numbers, are you look at the three, six, 12-month, nonfarm payrolls on the averages. They’ve been declining for a while. There’s certainly accelerated that decline. But we didn’t see a massive rally on the fixed income side. Rates are trending down a little bit this year. But if you look at rates over the last one-year period or frankly, over the last nine months, since September last year, they’re up across the curve. In spite of the fact that we’re seeing some slowing economic evidence.

Josh Rubin: So the jobs numbers had some impact on how people are thinking about the Fed’s behavior, but not necessarily on valuations in fixed income markets…

Phil Gronniger: Yeah, risk markets, again, took it relatively well on the fixed income side. In particular, when we look at corporate credit spreads, they’re still look at high yields and it’s in its fifth percentile, looking at historic levels, investment grade corporate credits. And that’s first percentile as far back as you can get data. So there’s seems to be no concern, if you will, that we’re headed for a bigger slowdown or that this economic revision in the non-farm payrolls is going to lead to further downward revisions elsewhere.

Josh Rubin: Phil, given how tight credit spreads are, is there an attractive place to be putting money to work in fixed income?

Phil Gronniger: Yeah, in fixed income, much like, if you think about U.S. equity markets, things are pretty rich, particularly at U.S. corporates. So there are areas of opportunity, to add additional yield or spread to fixed income portfolios in the securitized space, whether it’s agency mortgage-backed securities, non-digital mortgages, commercial mortgage backed securities and asset-backed securities that are trading inside their long term averages, but at more reasonable valuations, if you will, relative to corporate bonds. But fixed income investors, when they put capital to work, essentially two risks to be aware of. And that’s, credit risk or interest rate risk. Interest rate risk is the risk that rates rise and the value of the bonds go down. Credit risk naturally has the potential for default or naturally, deterioration in the economy or the business and the credit spread widens, which leads to a lower price.

We are hearing from a lot of clients that are thinking about adding more interest rate sensitivity to their fixed income portfolios and wait longer and maturities. A lot of that is based on the belief that the fed is going to start cutting rates more aggressively. And we heard Bessent, I think it was this morning even say that he thought the fed should cut 150 to 175 basis points.

And right now, the futures projections are more than 50 basis points through year end. And a probability of more than 25 basis points of cuts in September, now. And there’s a view that when the fed cuts the front end, the whole curve might come down. But if we look at a lot of the data, if you go back to the most recent said cuts from September through December last year, interest rates actually rose across the curve from twos to 30s.

The two year was up 75 basis points from mid-September to mid-December when the fed cut, and they cut 100 basis points. During that time frame the ten year rose almost 90 basis points as the fed was cutting rates. What leads to long and long rates coming down dramatically is usually a meaningful slowdown in the economy. So, a recession.

So betting long, if you will, going to a duration five, six, seven handle might not be very beneficial for fixed income investors. We like to say that if you all come to that sweet spot is in that 2 to 4 space, from a duration standpoint, you’re not making a bet, if you will, on rates coming down, to drive that return.

Josh Rubin: I guess thinking about all the calls for the fed to cut, it does seem like debate number one is simply will the entire yield curve shift down or you get, reduction on the front end, but the back end of the yield curve just stays at 4% plus. And in part two is, what do investors want for inflation protection. You know, we do know overall inflation pretty solid, still, pretty sticky in the mid 2% range. Core inflation possibly accelerating or at least remaining elevated as well. Closer to 3%. So how much can the fed you know, what are investors willing to tolerate at the front end of the curve, you know, if in theory, the Treasury secretary wants rates to go, a real yields to be negative at the front end of the curve again, do you think private investors are willing to tolerate that again?

Phil Gronniger: Yeah. The fed has a dual mandate. Most central banks around the world don’t really have that dual mandate. And it’s full employment and price stability. And we’re at a 4.2 unemployment rate. That’s the exact same. It was in July of last year. That’s up a decent amount. If we go back to July of 23, and I believe it was about 3.5%. When it comes to price stability, the Fed did a fantastic job bringing inflation down from a 40 year high. But as you noted, it’s gotten pretty sticky, particularly when we look at services. Services are not coming down. In fact, the core services were up a decent amount in the last monthly print. And that’s something to be a little concerned about, especially as we’ve seen goods now, as we mentioned earlier, start to factor back into adding to inflation as opposed to pulling it down like that was which was happening all of last year, similar to energy pulling it down now. So what should investors think or what should they expect? There’s certainly pressure from above. The administration would like to see rates lower because there’s a belief that it’s going to drive stronger economic activity. But that back into the curve is not going to move simply based on, what the administration wants or what the fed does on the front end. It’s going to be based on economic data. And while there has been some slowing, it’s likely that if that continues, you’ll see longer rates, perhaps drift a little bit lower. It’s highly unlikely that you would see a dramatic decline in rates without a meaningful decline in economic activity.

Josh Rubin: Adam, Phil, thanks for your time today, look forward to continuing the conversation soon.

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