History rhymes, but geography endures. ― Andrew C. Katen
I don’t like it when countries allow their geopolitical issues to trump economic interests. At the current point in time however, two of the world’s biggest economies are doing just that. So before we embark on any financial analysis, I’d like to provide some geopolitical context to the trade war between the U.S and China.
The geopolitical story is that of competition between the relatively united, smaller, New World (the Americas), and the relatively divided, larger, Old World (Eurasia, and Africa). The goal of the game is to control the oceans, for their efficient logistics. Since a unified Old World would use its larger resources and larger population to win the game, the strategy of the New World is to keep the Old World divided and control its key choke points (Strait of Hormuz, Suez Canal, Israel, Taiwan, etc.).
The Old World, much too heterogeneous, could only unite under the leadership of an authoritarian hegemon, but no one likes an authoritarian hegemon, so the British Empire, USSR, and others have failed to unify the Old World. Thus the New World wins time after time, and the USA controls the oceans. This game has to be played over and over again, simply because there is no other game.
China imports more oil and other raw materials than the USA now, and those imports are rising. The only way to secure those imports is to build a strong navy and control at least the Pacific and Indian oceans. A strong navy would also allow China to secure its export trade routes and investments abroad, project power, rally national support and more, so it’s really important.
This is the reasoning behind the fast growth of China’s defense budget. Officially it stands at $200 billion now and growing fast. Unofficially it may be even larger, and it may involve the corporate sector considering the recent Huawei spying scandal. Since by purchasing power parity (OECD data) the yuan is 49% undervalued compared to the USD, the military dollar buys more in China than it does in the USA. Considering all of the above, China may already be ahead of the USA in terms of military spending, and if it isn’t ahead yet, it will be soon.
The USA has no choice but to respond or risk losing its global leadership position. So Trump decided to increase military spending and start a trade war. The trade war is not a bad strategy. China is very financially overleveraged at the moment and it just began its deleveraging efforts. China’s trade with the US is heavily based on manufacturing, and the manufacturing profit margins are very tight, standing at around 5%, significantly smaller than the trade tariffs. In 2017 US trade tariffs on Chinese goods were 3.1% on average; now they are 18.3% and if the new round of tariffs takes place they will rise further to a 21.5% average.
China is financially overleveraged and definitely dependent on trade for debt servicing. Even more importantly, China is also overleveraged politically. China depends heavily on trade to improve technologically, to manage and manipulate its political stakeholders: foreign allies, trade partners, and its own population.
The potential Minsky moment here is grandiose. Managing China’s own population is its chief concern. The Arab spring, a social-media coordinated mass protest that toppled governments across the Middle East and North Africa, is a very real scenario for China in case of mass unemployment. And just 1% of extra unemployment equates to almost 10 million angry, likely heavy industrial factory workers, very united by the timing of things. So admittedly the USA picked a very sensitive issue, at a very vulnerable time, to press China on.
China’s response so far has been an up to 25% tariff on $60 billion/year of American goods, such as cars and agricultural products, a reduction in VAT tax of 3%-1%, support for its industry, and most recently a slight devaluation of the Yuan. Although the news headlines were making a huge deal of the Yuan devaluation, it’s so far quite small. The Yuan moved down only about 3%. It was the symbolism of passing the 7.0 CNY/USD line that triggered the news headlines, and perhaps the implied suggestion that the yuan could move further down. The US is standing to gain something close to a $100 billion dollars per year in additional tax revenues from the tariffs, with little cost to the consumer considering that China seems to be willing to pay for the cost of tariffs. So why the commotion? Fear of more tit-for-tat perhaps.
Who might be the winner to perhaps allocate money to? The major winners from the trade war are likely the countries neighboring China, such as Thailand (THD), Taiwan (EWT), Singapore (EWS), and Vietnam (VNM). Vietnam may especially benefit, in quite a diversified manner, as both Chinese producers are moving operations to Vietnam en masse, and their customers are switching their purchasing to Vietnam (see graph below). Asian Development Bank is forecasting a 2% GDP cumulative benefit for Vietnam’s economy as a result of the trade war.
Having said all this, as I’ve noted in recent Lead-Lag Report, emerging markets remain broadly an area to keep a close eye on, with China making up the majority of emerging market ETF allocations. But regardless of headline risk to China, there are plenty of non-China markets which stand to benefit no matter who wins the trade war in the short to intermediate term. Vietnam may be the strongest beneficiary.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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