US-China trade war creating market uncertainty

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Concerns about US President Donald Trump’s foreign policy initiatives, particularly over trade, took a back seat in May – but they didn’t go away. Trump’s stance has since become ever more combative, sparking a US-China trade war that is creating market uncertainty and is starting to hurt business.

Dave Lafferty, Natixis IM provides some insights into how the ongoing trade war will play out and the knock on effect as we head towards US mid-term elections in early November.

Tariffs become a reality

Until 5 or 6 weeks ago, I viewed Trump’s tough trade talk as mostly rhetoric designed to be an opening gambit for getting modest trade concessions. Underneath the bluster, surely his pro-business instincts would recognize that upending the global trading system would be bad for the US and global economy, not to mention, potentially undermine the benefits of his hard-fought tax cuts. Ultimately, I believed Trump wanted some “small wins” that he could take back to his populist base in the Midwest, but he wasn’t looking to do any real damage.

Today, I’m less sanguine. Trump’s trade talk has taken a darker turn in recent weeks.  Trump is doubling down on tariffs and proposing restrictions of Chinese investment (CFIUS) and tariffs have moved from the “proposal” stage to reality. The latest leaked story, that Trump is actively considering withdrawing from the WTO, is troubling. It would be almost impossible to do (business and Congressional blow-back would be HUGE), but the fact that it’s even been discussed is scary enough. It highlights how little this president understands the value of global trading system.

Trump famously quipped that “Trade wars are easy to win.”  That’s nonsense. Nobody wins a trade war. Moreover, while the Chinese are more export dependent than the US, they also have more levers to pull. They have command of the RMB value, over $3 trillion of foreign currency reserves, and Xi is effectively president for life.  (Trump’s mandate may die as early as the November mid-term elections if the Democrats take the House of Representatives, which is probably a 60% chance right now).

Is Trump playing by the rules?

Trump is correct that the Chinese have not played by the rules, largely ignoring intellectual property rights and effectively stealing technology. However, there are better ways to hit back than tariffs, which hurt everyone.  This is a key distinction between the China fight and the NAFTA fight. In the case of China, they aren’t “playing by the rules.” In the case of Mexico and Canada, Trump just doesn’t like the rules. (i.e., the NAFTA agreement).

Almost as evidence that Trump has turned even more combative on trade, there are now small factions within congress who are looking to limit his trade authority. House and Senate members feel the heat when businesses start talking about leaving or laying off workers, Harley Davidson for example.   This morning, the US Chamber of Commerce (the largest business lobby in the US) began a campaign against Trump’s tariff policies. Trade talk, which is now becoming trade action, is creating uncertainty and starting to hurt business.

Inflation and higher prices are the least of my worries. In the past 20+ years, supply chains have become globally integrated. Trump represents the biggest threat to global trade since the creation of the WTO. Manufacturers source parts and labor from all over the world. Services (like banking, asset management, consulting, etc.) are globally integrated. Disrupting these global supply chains is a bigger risk than the dollar value of the tariffs themselves. The US simply can’t back away from the global trading system in some misguided attempt to reduce our current account deficit.

Will China go on a Treasury buying strike?

The larger, but more remote (less likely), risk is that trade arguments spill over into the capital markets. The current account (imports vs. exports) is mirrored by the capital account (portfolio flows and foreign direct investment – FDI) which has currency and interest rate implications. Yes, the Chinese sell a lot more goods to the US than they buy from the US, but they also buy a lot of US Treasury debt that keeps our interest rates in check.  The Chinese are unlikely to go on a Treasury “buying strike” – it would cause their currency to appreciate too much, but it highlights how this can spill over into rates and FX values which may have an even larger effect on US growth.

The threat to global supply chains

To the point above, we already see the Chinese managing the RMB lower.  In the last 3 months, since all the trade rhetoric has picked up momentum, the Chinese have managed the RMB almost 6.5% lower in what is certainly a “stealth devaluation” – that’s more than twice the 3.0% explicit devaluation that rocked markets in August of 2015.

Global trade has been slowly improving after faltering a bit in 2014-2016. This is another headwind the global economy doesn’t need, particularly as we see signs of an interim slowdown in Europe, England, Japan, and China. The uncertainly of trade wars will continue to create volatility for the capital markets. Having pushed the issue this far, and really taking a hit on the “family separation” issue, Trump is going to become more combative, not less, heading into the midterm election.

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