Trade tensions begin to bite
Trade tensions have escalated substantially in the last year, between the United States and China as well as between the United States and its major trade partners. While it has taken some time, the effects of US-China trade tensions are becoming clearer in both trade and economic data, as is the redirection of US trade patterns from China to other emerging economies.
The policy tools brought to bear on the US-China trade dispute have evolved from a focus on trade deficits, negotiations, and tariffs to measures to address concerns over market access, industrial policies, intellectual property protection, and ultimately national security. Issues relating to national security could be particularly troublesome, as they are non-negotiable to a certain degree and hence may preclude a comprehensive resolution.
To the extent a narrow deal is agreed on between the US and China, we also would be highly skeptical of its scope and duration. In the US, the narrative of China as a national security threat and strategic adversary has become embedded on both sides of the political aisle, which adds an element of uncertainty to the economic outlook.
Uncertainty is the enemy of growth and leads to increased US recession risk in 2020, although a US recession is not our base case scenario.
A MULTI-FACETED TRADE DISPUTE
It is useful to remember that the US is engaged in a multi-faceted trade dispute. It has either threatened or actually implemented tariffs not just on China, but also many other trade partners. In the case of its other trade partners, the US has subsequently reached trade agreements with South Korea and with Mexico and Canada, although the latter has not been ratified by Congress yet. A US-Japan trade agreement is in the final stages of negotiation, while negotiations toward a US-European Union trade agreement is still in early stages.
In the case of China, however, the action so far has come both in the form of tariffs and in the form of more targeted measures, directed against specific entities, such as
Huawei and ZTE, or specific issues. Importantly, given the national security implications of the US-China dispute, we should expect more restrictions related to technology equipment and services.
In total, US policies mark a substantial shift away from free trade. Currently, about 45% of US imports from all trade partners are either subject to or threatened by new tariffs.
The annualised run rate now exceeds $80 billion on approximately $400 billion of US imports. Assuming all the tariffs threatened to date are actually imposed, this figure would more than double to $180 billion per year on approximately $1.07 trillion worth of imports, about $490 billion of which would come from China.
The US’ trading partners have responded with their own tariffs on US exports. So far, retaliatory duties have been smaller, with the global total at a run-rate of just over $20 billion of tariffs on a little more than $90 billion of US exports.
If all threatened retaliatory tariffs are implemented, these figures would rise to $28 billion and $98 billion.
TRADE DEAL SCENARIOS
We see four broad outcomes possible for US-China trade talks. However, even if the US and China reach a deal regarding trade, the evolving view of China as a national adversary, rather than just an economic competitor, is critical to keep in mind. The tension between the US and China is not going to go away, but instead will likely increase in our view.
We consider the chances of a comprehensive deal to be very low, at 5%, in light of the national security stresses in the US. We see better prospects for a narrow deal that involves China purchasing more US commodities, agreeing to intellectual property protections, and improving market access while leaving the tougher issues around national security, technology competition, and industrial policies unresolved, at 25%.
An agreement to pause hostilities is another option, at 30%, but this should be seen as more of a stopgap, not true progress. It would leave US tariffs at current levels rather than raising or eliminating them and would force businesses to deal with ongoing uncertainty over the long-term state of the overall economic relationship and their supply chains.
Finally, we believe it most likely that the tension between the US and China escalates, at 40%. This would involve failure to agree on a resolution in October and would lead to increased tariff rates and further retaliation from China.
UNCERTAIN OUTLOOK
Overall, the outlook is best characterised by uncertainty against a negative backdrop – among other factors, negotiations to date have created bad blood, and recent US commentary has depicted Chinese President Xi Jinping as an adversary. Our negative perspective also stems from US security concerns. Unlike other countries, for which the US delineates between the government and the private sector, Washington sees ‘zero daylight’ between the Chinese government and Chinese companies.
This underlying skepticism regarding China’s motives and long-term intentions are shared across the Republican and Democratic parties. This is a rare case of bipartisanship and should be understood as an ongoing source of tension between the two countries. On the back of these rising suspicions, the broader US-China relationship is suffering.
Chinese foreign direct investment into the US declined by almost 90% from 2017 to 2018. The share of Americans who view China and the US as ‘mostly partners’ declined by 35 percentage points. And the number of US student visas issued to Chinese nationals declined by 10%, with anecdotal evidence indicating that tightening access to US universities has accelerated since 2018.
INVESTMENT IMPLICATIONS
The increasing uncertainty around the US-China trade relationship, not to mention the US’ relationships with its other major trading partners, has increased the risk of recession in 2020. Recession is not yet our base case scenario, but we believe the risk is at its highest in over a decade. However, context is important.
Recession need not imply an event of the magnitude of the global financial crisis, but rather two consecutive quarters of negative GDP growth. In fact, there are significant buffers in place against a deep recession today, even if there were to be a near-term hit to corporate earnings — the unemployment rate is at a 50-year low, and consumer balance sheets are in a much more resilient position than before the crisis. Furthermore, trade-related uncertainty, to the extent it is not resolved in negotiations by year-end, could sustain central bank accommodation well into 2020.
Our broader concern is that additional central bank infusions of liquidity, such as the recently announced €20 billion ($32.6 billion) per month of securities purchases by the European Central Bank, are likely to continue pushing up the value of financial assets even as economic fundamentals weaken. That implies that if there were to be a recession, valuations could face substantial downside. That said, we must emphasise that recession is not our base case scenario.
Nevertheless, the risks and the economic backdrop make developed markets duration and credit unattractive. With over $15 trillion of government debt in negative yield territory and over $500 billion of corporate debt with negative yields, it makes more sense to invest in US dollar cash balances or emerging markets debt, where real yields are positive and where the currency risk associated with dollar strength has declined in tandem with the Fed’s easing trajectory.
Equities are not cheap, but they are less expensive than debt. We favour an overweight to equities but prefer de-risking by focusing on companies that can sustain high returns on capital through enduring competitive advantages and strong balance sheets while still trading at attractive valuations. Finding attractive valuations has become more challenging, and this is where security selection and deep, forward-looking fundamental research are critical.
The trade war also makes some sectors especially vulnerable. Some consumer discretionary companies may find it tough to pass through rising prices if tariffs increase. The technology industry is likely to be the target of non-tariff barriers. Unfortunately, there is little clarity on the form these restrictions might take — they could be narrow and affect specific companies, or they could be wide, affecting semiconductor manufacturers for example.
Beyond these two sectors, a range of companies and industries are likely to be affected as the two largest economies in the world engage in a trade war. To determine the appropriate implications for valuation in this environment, investors need to focus on the actual cash flow implications for the individual company and try to forecast the medium to long-term impacts of the trade situation.
Ron Temple is a portfolio manager/analyst at Lazard Asset Management.
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