Originally published on 4 Sept. 2019
By Bluford Putnam
As any seasoned general will advise, even well-thought through battle plans rarely survive the first encounter with the opposition without some adaptation. Collateral damage, unexpected tactics from the opposition, long-lasting conflicts, and permanently changed landscapes are all typical aspects of warfare. Trade wars have many similarities.
Equity market participants are now settling in for the long haul and are increasingly aware of the event risk associated with the unanticipated developments that come with the trade war. Temporary tariffs fired as first shots are now looking permanent and at higher rates than initially advertised. Opposing countries have shifted buying plans, with long-term implications. Company supply chains have been dislocated, and they will never go back to their pre-trade war conditions, as post-trade war long-term risks will remain in the psychology of business executives and have to be managed through supply-chain diversification. Tariffs are a tax on trade, and regardless of who pays the tax; trade is hurt. Thus, global trade is slowing, and as global trade slows, so does global economic growth. Monetary policy is ill-equipped to cushion the effects of a trade war, because the challenge for businesses is the trade war, not rates, which are already quite low. And, while one trade war front might see a cease-fire, other fronts could open up, such as Europe.
I. Damage Assessment
Equities versus the Economy. The trade war has hit equities harder than the US and Chinese economies, although the Chinese economy is hurting a little more than the US. The reason equities take most of the pain is because some of the tariffs and costs associated with supply chain disruption get absorbed by reduced profit margins such that the impact on the US economy is limited to slowing economic growth, yet no recession is not likely.
Companies are willing to absorb most of the costs of tariffs and supply chain disruption because we are in the Internet Era of price transparency. Price transparency makes it easy for consumers to comparison shop, which they do aggressively. Companies have lost pricing power, and so companies now focus on maintaining market share and profit margins. Raising prices would virtually guarantee a loss of market share. So, profit margins take the hit, and equity valuations are seriously impacted by any escalation of the trade war.
By contrast, when we think of the economy, the main driver of US GDP is consumer spending, and consumers are likely to continue to spend so long as they have a job and are confident of keeping that job. So far, there has been little to no impact on the US labor market, since companies are maintaining production to keep market share. The unemployment rate remains comfortably below 4%, so spending is robust.
What impact there has been on US real GDP has come from declining business investment. Companies' long-run business investment plans have been delayed or indefinitely postponed, and this can clearly be seen in the investment category of real GDP. This category is relatively small in its total impact on GDP; however, the US economy has clearly decelerated even if a recession is unlikely.
China is a somewhat different story, because its economy is much more dependent on exports than the US economy. Chinese exports to the US have dropped; however, China has been able to increase its non-US exports. The result has been flat exports overall; no export growth, but avoiding a sharp decline, too.
Chinese yuan. The Chinese yuan is the canary in the coal mine. When the trade war escalates, the Chinese yuan depreciates, and vice versa. Developments in August 2019 made the currency impact all the more important for markets. Prior to the deterioration in trade relations when the US unexpectedly announced a large new expansion of tariffs, the Chinese authorities had managed to avoid a depreciation of the Chinese yuan through the psychological threshold of 7.0 CNY per USD. Before the US abruptly ended the ceasefire period, the general view was that if the Chinese yuan remained stronger than 7.0 to the dollar (that is CNY/USD 6.9 or 6.8), then the US would be placated. When the US escalated the trade war in August after the US Treasury Secretary had told the public he had just had a productive set of discussions in Shanghai with plans to continue the talks in the US, the market was surprised. Equities dropped sharply, and the exchange rate moved to CNY/USD 7.05 and then later to 7.10 and 7.15.
There were two interpretations of the currency move. The US Treasury accused the Chinese of managing a devaluation. Most market analysts, however, took the view that the escalation of the trade war naturally would hurt Chinese exports and encourage capital to leave China, meaning that market forces were the driver of the depreciation. The primary metric to settle this argument will be data on Chinese foreign reserves and holdings of US Treasuries. This data on foreign reserves arrives with a lag of several months. To prevent a currency from weakening, a country needs to sell its foreign reserves and buy back its own currency. To prevent a currency from appreciating, a country buys more foreign reserves and sells its own currency.
There is no question that during the period of 10%-plus Chinese real GDP growth in the early 2000s, China accumulated billions of foreign reserves in an effort to prevent the currency from appreciating too rapidly. Now though, depreciation is the challenge, and we will have to see when the foreign reserve data for August is released if there was a sharp decline in reserves in an attempt to limit the depreciation, or very little change indicating that market forces were allowed to set the value of the US dollar versus the Chinese yuan. Only if there was a clear rise in foreign reserves would one be able to conclude that China actively engineered the depreciation of its currency.
Lastly, we note that as the Chinese yuan depreciates, it works as a direct offset to higher US tariffs. In terms of US dollars, a 10% rise in tariffs would be compensated fully by a 10% decline in the currency.
II. Limits of Monetary Policy
While President Trump has advocated aggressively for the Federal Reserve (Fed) to lower rates to compensate the economic damage being done by the trade war, and the Fed has complied to an extent, there is little likelihood of the rate cuts making much difference to future economic performance in the US. The challenge is that the US economy's deceleration from 3% to 2% real GDP growth was due (a) to the wearing off of the December-2017 tax cut that temporarily raised growth in 1H/2018, and (b) the fact the trade war has slowed business investment due to the massive corporate uncertainty over tariffs and supply-chain impacts that has hit equity prices. If US short-term rates were lowered to 1% or even 0%, it would not help grow business investment that is constrained by the uncertainty of the trade war. Fed Chair Jerome Powell has argued that an ounce of prevention is worth a pound of cure, so why not cut rates. Unfortunately, one gets no preventive effect from giving a sugar-pill when the medicine required is a de-escalation of the trade war, over which the Fed has no control.
III. Prospects for a Trade Deal and/or the Opening of New Battles Fronts
No deal in sight. The trade war ebbs and flows, but there seems little chance of a major, path-breaking deal. A deal right now does not suit either side.
If President Trump agrees to a deal, no matter what deal, he is likely to face considerable criticism from parts of the Republican Party seeking a very severe deal with hard penalties regarding Internet security and intellectual property rights. And for the Democrats, being tough on China is a universal campaign theme, even if most Democrats would choose different tactics. President Trump may be best positioned for the 2020 elections by maintaining a tough stance on China and not agreeing to a deal, thereby strengthening his position with key battleground states as well as a key portion of the electorate.
In China, President Xi Jinping has to make sure that he does not yield to any bullying by the US. He has very strong internal support and a general willingness to accept whatever pain is involved to stand up to the US. This is a 5,000-year old mindset. Throughout the history of civilization, China has been regarded as a great country and world leader. The last 200 years of a reduced role are seen as a blip in history, and that China is on its way to regaining the respect it feels due for a great power. To focus only on the fact that China is suffering more economically than the US misses the point entirely from the perspective of Chinese leadership. President Xi can agree to a win-win deal where there is give and take, but he cannot agree to a deal in which the PR from the US would claim trade war victory.
US versus European Union. Most of our trade war analysis has focused on the US and China. Going forward, there is a reasonable probability that a new front in the trade war will be opened by the US with the European Union. As the G7 meeting in August demonstrated, there is a rather intense dislike in Europe for the policy approach the US has taken. US-European trade is highly interwoven and exceptionally complex. If the trade war were to expand to the EU, then equities may experience another bout of weakness, and Germany may be driven further into recession, as its automobile industry is already suffering and that is where the tariffs might hit very hard, if imposed.
US listening to equities. US President Trump does appear to care about how equity markets respond. If an escalation of the trade war causes a sharp drop in equities, then some backtracking becomes more likely. The Chinese have tended to be more surgical in their tit-for-tat retaliation to US escalation, using their buying power with high-profile products such as soybeans. That tactic has been largely used to its fullest, so now, with the Chinese yuan trading weaker than CNY/USD 7.0, the Chinese are more likely to allow market forces to weaken the currency with further depreciation if the US escalates the trade war.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.