Trade wars are back in vogue.
President Trump has threatened to retaliate against the Chinese retaliation to his decision to sign off on aluminium and steel tariffs on March 8th. The accelerated pace by which the US and China are announcing these unilateral measures (not to mention the increase in the numbers involved – “I see your USD 50bn, and raise you USD 100bn”) means the escalation of tension between the two economic superpowers is palpable.
Investors think they have seen this playbook before – almost 90 years ago to be exact – and this has had an unsettling effect on global risk markets.
As most people are aware, in June 1930 the US imposed the Smoot-Hawley tariff which set a 20% duty on imports – a move that prompted retaliatory responses from its then largest trading partner, Canada, and several European countries.
For many, this was a key contributing factor deepening and extending the global economic contraction that is now called the Great Depression.
Indeed, as noted in an earlier Market Insight, since the Great Recession plenty of economists have warned about the threat to global trade, and by extension economic growth, from countries resorting to protectionist measures in an attempt to secure their share of the “global economic pie” just as they did 90 odd years before.
Given such precedent, the G20 communiqués after 2009 repeatedly pledged to renounce protectionism. That is, until March last year, when Trump’s economic team weakened the commitment to one that works…
“…to strengthen the contribution of trade to our economies. We will strive to reduce excessive global imbalances, promote greater inclusiveness and fairness and reduce inequality in our pursuit of economic growth.”
That last year’s communiqué re-write marked the beginning of the end of the international entente cordiale over global trade now appears confirmed by the escalation in trade tensions between the US and China.
Given the familiar narrative about protectionism exacerbating the Great Depression, investors are becoming much more circumspect on the economic growth trajectories in the US and China.
This is clearly apparent in crowd-sourced economic growth sentiments, which until early March were trending higher but have now reversed direction – see exhibit below.
Exhibit 1: Crowd-sourced Economic Growth Sentiment – US and China
In terms of the speed and depth of the sentiment reversal, it is considerably greater in China than in the US, indicating the global crowd believes the impact to be more damaging to the former than the latter. This likely reflects the more open nature of the Chinese economy, meaning it is more vulnerable to a downturn in global trade, as well as the significant fiscal stimulus programme the US is embarking on, which will serve to mitigate any drag from external sources.
Certainly, these arguments carry more weight with the public than Trump’s flippant suggestion on Twitter that for debtor nations like the US, trade wars are “good and easy to win”.
Looking at US bilateral trade balances, it is easy to see why China is the focal point for the Trump administration. It is the single largest contributor to the economy’s USD 800bn annual trade deficit. Moreover, even when one extends the definition beyond goods – the primary target of the tariffs – to include services, where the US runs a sizeable surplus vis-à-vis the rest of the world (USD 240bn last year), China is still a long way out in front with a bilateral surplus of USD 340bn per annum.
Importantly, China has been running a large bilateral trade surplus with the US for many years and President Trump, rightly in this author’s view, considers the sustained nature of this external imbalance to be of equal importance.
That said, if one looks at the other countries with sustained and significant bilateral trade surpluses vis-à-vis the US (excluding Mexico’s whose bilateral trade numbers are not reliable because of re-exports), second after China is Germany, followed by Japan. Taking into account their relative economic size, these external surpluses are not a million miles away from China’s in magnitude. China’s bilateral trade surplus with the US equates to 2.8% of its nominal GDP, the equivalent figure for Germany is 1.8% and 1.1% for Japan.
Consistency of policy – admittedly not something one readily associates with President Trump – suggests the US should also consider tariffs against German and Japanese exporters. Indeed, Peter Navarro, head of the White House National Trade Council – a forum established by President Trump after his election victory – and who appears to be making a comeback in terms of influence in the administration, has made just this point many times in the past.
As the tortured nature of the Brexit negotiations have made all too plain, when it comes to the EU, trade issues are decided at the supra-national level, meaning that if the US wanted to apply sanctions against Germany, it would have to apply it to all EU member states and any retaliatory action that followed would be at the EU level.
The optics of such a move, especially in light of the continued deterioration in political relations with Russia – a topic covered in a recent Market Insight – are far from great. Yet, in the event that neither the US nor China backs down, it is hard to see how the EU will be able to avoid getting dragged in as well.
Such perceptions could explain why EU and German crowd-sourced economic growth sentiment have also taken a bit of a hit over the past few weeks – see exhibit below. (NB: Japanese economic growth sentiment has also taken a tumble).
Exhibit 2: Crowd-sourced Economic Growth Sentiment – EU and Germany
In short, the crowd-sourced sentiments indicate that global growth dynamics remain synchronised, but not in a positive direction as was the case just several weeks ago. Rather, it is starting to look more like a broad-based swoon.
Concomitant with declining positivity in relation to economic growth in the leading economies, the evolution of crowd-sourced future inflation sentiment (a proxy for private sector inflation expectations) shows a clear disinflationary tang.
The dominant colour in the outermost circle in the exhibit below is predominantly red, which occurs when future inflation sentiment has fallen over the last calendar month (the magnitude of the change is shown by the corresponding figures).
Exhibit 3: Crowd-sourced Future Inflation Sentiment Momentum
The public’s collective perception of the emerging macroeconomic environment, namely one of softening economic growth and disinflation, is not obviously conducive to supporting global stock markets, which have been struggling since late February – the underperformance of the market-leading tech sector (for reasons entirely unrelated to the macroeconomic situation) has certainly not helped.
Exhibit 4: Global Equity Sentiment Heat Map
When one looks at crowd-sourced sentiment towards global equity markets, the mood is still fairly constructive, with most standing above their long-run averages which are viewed as equating to neutral – see exhibit above.
What this snapshot does not convey, however, is the momentum of crowd sentiment has, like economic growth and inflation sentiment, rolled over in a number of countries. The outermost ring in the exhibit below, which plots the change in equity market sentiment over the past month is predominantly red, indicative of fading positivity. A combination of still elevated, but declining, crowd sentiment towards equities constitutes a near-term headwind for stocks.
Exhibit 5: Global Equity Sentiment Momentum
What about government bonds?
One would naturally expect them to be the more favoured asset, especially as the change in public perceptions about the macroeconomic landscape could encourage the Fed to moderate the pace of its monetary policy normalization – interest rate futures markets are already anticipating a slightly less hawkish Fed.
Generally, this perception would be correct. However, there are some concerns that China could use its substantial USD 1.8trn holdings of US government paper – the capital account offset to its sustained bilateral surpluses with the US – as a “financial weapon of mass destruction”. (Rumours in mid-January that China was considering stopping purchases of US government bonds, subsequently denied by officials, caused a Treasury market wobble).
This sounds like a credible threat, but in reality it isn’t. China is unable to wreak havoc in the US Treasury market for fairly simplistic reasons.
China has accumulated large holdings of US government paper as a direct result of a mercantilist policy, which deliberately short-circuited the natural tendency of the RMB to appreciate in the face of large external surpluses, helping to sustain them and the positive growth impetus. Selling its US Treasury holdings and repatriating the proceeds back into RMB would put its currency under massive appreciation pressure. Not only would this effectively undo all of their previous policy efforts, it would put additional, considerable, strain on a key sector of their economy being targeted by the US via tariffs. Not an obvious winning strategy.
If anything, the bias of the Chinese to increased trade tension would be to weaken their currency (media reports suggest a gradual RMB depreciation is being considered) to support the external competitiveness of its export sector. To the extent that currency weakness is not the result of market forces, such action would require increased official purchases of USD-denominated financial assets including, quite probably due to the depth of market liquidity, US Treasuries.
Of course, China could convert the proceeds from scaling back its US Treasury holdings into other US financial asset classes – equities, cash or real estate. However, it is difficult to see much merit in such actions.
If the Chinese were to make the asset allocation shift in a manner designed to inflict as much pain as possible on the US government bond market ie. swiftly, then real estate would be too illiquid to absorb the resultant inflows.
Publicly traded equities are more liquid, and therefore a more attractive alternative. However, a Wall Street rally triggered by Chinese official buying (or the expectation of it by investors seeking to front-run official inflows) would seem to be a very strange way to punish the US in a trade war. Moreover, the US administration would be very sceptical of a sizeable uptick in Chinese ownership of its companies (the definition of strategic assets would, we suspect, become rather wide).
As for cash, it is just a perpetual government bond with a lower yield than a Treasury (zero in fact). An asset, one should add, the Fed would be more than happy to supply in any amount. After all, how does one think the Fed, an institution that has fine-tuned its bond market interventions during its QE years, would react to a surge in US government bond yields triggered by the actions of a foreign government whose aim is to undermine confidence in its financial markets? Sitting quietly on the sidelines doesn’t seem at all likely.
The other options for China would be to convert their USD proceeds into other liquid currencies, such as the EUR, GBP or JPY, or gold (one would think cryptocurrencies are an obvious no no). Given the magnitude of the portfolio shift, the slippage to China would be substantial in fiat currencies and tremendous in the yellow stuff.
Moreover, the implied sharp appreciation of the destination currencies would be very poorly received. One of the key lessons of the Great Depression is that at times of global economic stress, currency weakness is a valuable offset and European and Japanese governments are more than well aware of this. In fact, in an echo of the Great Depression, capital controls could make a comeback in the event of a trade war to deal with volatility arising from sizeable international portfolio flows. (This may seem like an anathema to the EU’s free movement goods/labour/capital objectives, but as we learned in 2013 with Cyprus when the integrity of the single market is viewed by the region’s policymaking elite as being jeopardized all bets are off.)
Such considerations do not mean that it could not happen. It could. But one has to ask, why China would risk antagonising other key export markets by actions that have a limited detrimental effect on their original target, the US. It doesn’t make much sense, economically or politically.
The absence of an effective Chinese economic “nuclear policy option” against the US, combined with the obvious damage a trade war would inflict on a key sector of China’s economy, plus President’s Trump well-known penchant for tough negotiation tactics, has many market professionals convinced that, while noisy in the short-run, the two leaders will follow the advice of the great Sir Winston Churchill and will not turn “jaw jaw” into “war war”.
The optimists may be right, and given the increasing cautiousness towards the global macro backdrop shown by the crowd-sourced sentiment indicators, this confidence would be rewarded by the fillip global risk assets would experience by any agreement.
However, even if the current trade spat does end benignly, longer-term one can’t help thinking that this episode will, with the benefit of hindsight, be viewed as another wobbly step down the inevitable path to conflict between the US and China – an outcome discussed at length in an earlier Market Insight.
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