Originally published August 5, 2019
By Seema Shah, Chief Strategist, Principal Global Investors
This morning, investors woke to a significant escalation in the U.S./China trade tensions. Following President Donald Trump's abrupt decision on Thursday to propose 10% tariffs on another $300B of Chinese imports from September 1, China's yuan has breached the RMB 7 per dollar threshold for the first time in 11 years. This was followed by reports that the Chinese government has asked its state-owned enterprises to suspend purchases of U.S. agricultural products.
Global equities have tumbled, global bond yields have rallied with U.S. 10-year Treasury yields hitting 1.75%, and the Japanese yen appreciated so severely it prompted an emergency meeting between the BOJ and MOF.
Where do things go now?
From China's perspective, they need to attack President Trump's key vulnerability: the 2020 Presidential election. With that in mind, it is in China's strong interest to hurt President Trump in politically sensitive states (i.e., via bans of strategically important U.S. imports) and/or to accelerate his demise as president by spurring a renewed and significant economic downturn in the run-up to the 2020 election.
Trade uncertainty is already weighing on U.S. companies, likely prompting many to pause overseas investment plans, risking global capital spending and damaging business sentiment. President Trump's repeated reneging on trade deals is now set to take its toll. Remember too that American consumers, who have been resilient in the face of weakening economic activity, will be more vulnerable to the latest round of tariffs given consumer goods dominate those Chinese imports.
What's more, the U.S. dollar, already feeling the heat from President Trump's decision to threaten new tariffs and the U.S. Federal Reserve's (Fed) hawkish policy rate cut last week, is now under further upward pressure from China's decision to permit depreciation of the yuan. Note too that a weaker yuan will also have significant repercussions globally as it could result in a wave of competitive depreciation among other Asian currencies as they struggle to compete with China's overnight improved competitiveness. In fact, several economists consider significant yuan depreciation the greatest risk to global growth.
A very sharp depreciation of the yuan is, however, unlikely as it would likely trigger capital outflows, forcing authorities to introduce capital controls and thereby, unsettle foreign investors into China. As such, China is likely to also consider other retaliation measures, including informal boycotts of important U.S. products and strategic geopolitical pressure - keep an eye out for North Korea-related headlines. However, mass sale of U.S. Treasuries still seems unlikely given the significant damage it could inflict on China's own economy.
Of course, President Trump is unlikely to sit back and watch the mess unfold. Investors are nervously waiting to see if he will consider unilateral FX intervention in order to weaken the U.S. dollar. Other counter-retaliation measures are also likely, including increased tariffs on Chinese imports and new restrictions on exports of technology to China. But while China's growth will undoubtedly be dented by such moves, from the Trump administration, this is an act of self-harm.
After all, several U.S. technology sub-sectors have significant exposure to China via supply chains. Non-U.S. sales represent almost 60% of the S&P 500 tech sector - the highest of any group, making it the most reliant on global growth. I expect the tech sector to be one of the worst-hit in the approaching market fall-out. Consider too, that between April 2009 and October 2018, earnings growth for the MSCI ACWI index excluding technology was just under 400%, whereas for the MSCI tech sector alone it was over 950%. If the tech sector stumbles, the broader market stumbles.
Economic and market impact
In the space of one week, the two elements that had been propping up markets have reversed. The Fed disappointed markets with an underwhelming message about further rate cuts, while trade tensions have returned. Market complacency has received a hard shot of reality.
We now need to prepare ourselves for a sharper U.S. equity market correction as investors reprice the risk to the economy from the trade war and the stronger U.S. dollar. How long the equity market correction will last depends on the Fed's response and the Chinese economy's ability to outlast Trump's Presidency.
China certainly has the ability and space to provide further monetary and fiscal stimulus, but whether or not measures will be able to stabilise the economy effectively is questionable. On President Trump's part, it surely isn't in his interest to have a deep and sustained equity market correction, in turn precipitating an economic slump, with the 2020 U.S. Presidential elections fast approaching. And while the Fed will almost certainly cut policy rates in September, that may not be enough to turn things around so quickly.
Yet, national pride may mean both sides continue to hold on, even as their grip loosens. A circuit-breaker, in the form of a sharp economic/market slump, may be the only factor that prompts both the U.S. and China back to the negotiating table.
(Conspiracy theory alert: Imagine that the Fed cuts policy rates several times over the coming months, and then President Trump decides, as he has in the past, to remove the threat of new tariffs, triggering a strong equity market bounce just as voters start to focus on the upcoming 2020 elections. What a boon that would be for President Trump.)
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.