Will today’s trade tensions permanently disrupt global value chains and lead to a new Cold War?
The inescapable conclusion is that the world is moving inexorably towards another extended period of political and economic divergence, with some similarities to the original Cold War, but in many ways more invasive and more dangerous for investors. The unintended consequence will be a three-track world, with a generalised return to heightened state intervention. Ultimately, this could lead to three distinct ‘camps’ (U.S.-led, China-led and the ‘Old World Order’) of increasing economic and political interdependency and limiting investment outcomes.
This approach will likely result in an acceleration of the adoption of certain new technologies, but at a higher risk of permanent dislocation of trade routes and long-lasting prejudice to investment returns. In this scenario, the fragmentation of the world into three main camps will become entrenched. As a result, inflation and interest rates will rise, fuelling inequality. Consequently, state intervention will increase as populations become more vocal about their deteriorating living standards. Investors may not be able to maintain their current freewheeling status, as first public-sector plans and then large corporate asset owners could find themselves being channelled into restricting investment exposure to markets in the ‘other’ camps.
Trade Drives Foreign Policy, Drives Military Doctrine/Action
What Can We Learn from Historical Precedent?
The parallels to the current trade war are limited. China is the second (for now) largest economy in the world, with a resilient population, a stable, unchallenged leadership and a famously long policy horizon. As for the entertainment industry, China’s movie theatre market is bigger than the U.S. and as a result does not suffer from unflattering Hollywood depictions – at least for now.
Given consensus in Washington is currently so uniformly negative on China’s perceived unfair practices, the likelihood of a resolution, now or in the future, is extremely low – the best the markets can hope for is an uneasy truce, perhaps best described as a relationship of mutual discomfort.
Some Believe the Earth is Flat
Clearly this is the paradigm of globalisation and many of us grew up with it. In the aftermath of World War II, the creation of GATT (General Agreement on Tariffs & Trade) effectively became a catalyst for increased global trade and economic growth. In 1995, GATT was replaced by the WTO (World Trade Organisation), which expands the scope to include services and intellectual property and cements the rules-based framework for international trade that most countries use today.
For more than 70 years, the established doctrine of the U.S. was to champion these organisations as they facilitate trade, which in turn stimulates demand for the freedoms and values enjoyed by democracies. All of that abruptly changed in 2016. Today, ideology is driving U.S. policy, not economic considerations. The world view that is built on the belief that the trade deficit is the key data point, is driving the current tariff war, on the assumption that the other side will be brought to heel in short order. It would be disingenuous of me to ignore the fact that both assumptions seem to be misguided. Put simply, tariffs are a blunt instrument that essentially raises a tax on the economy and are inflationary over the longer term, hurting both sides in the process. Strangely enough, no U.S. automaker was clamouring for protection from imports in 2016.
Value Chains – The Formula has Changed and the Impact is Real, Immediate and Permanent
It should be stressed, however, that value chains are in perpetual evolution, responding to changes in conditions, the implementation of new technologies and the fast-increasing demand from the developing world. The practice of arbitrage of unit labour costs is now outdated, but differentiation of service and knowledge intensity is key. This process should lead to further polarisation between countries and companies, across the developed and emerging asset classes.
What changes all of this, is the injection of politics into the formula. This can only have a destabilising and detrimental effect on costs, margins, reliability, business confidence and ultimately, investment returns. But perhaps equally importantly, it upsets the relative clarity of expectation regarding the likely winners and losers going forward. So, trade, industrial and economic policy designed based on the ‘old world’ view of optimisation of the value chain are unlikely to bear fruit. The new policies must consider politics and foreign affairs as well as service capabilities, workforce skills and digital infrastructure.
How Have Companies Responded?
BMW has reacted the same way, cutting its production targets from the South Carolina plants and mulling increased production onshore in China instead.
Trade-related risks still predominate as top risks to global and domestic growth*
The Anatomy of a Trade War
In many ways, the United States has important structural advantages in a trade war. It is the biggest economy in the world, it has a lot of resources, it is an attractive market and it has both human and financial capital to bring to bear. But it also has weaknesses. The biggest is its transparency. It means that it is a ‘target-rich environment’ making it easy for the counterparty to identify areas of the economy where each counter strike will do the maximum damage, as we have recently seen with soy bean farmers’ record bankruptcies. The evidence of economic pain being inflicted on sections of both economies makes it plain that trade wars do in fact hurt both sides.
Further, strategists place a great deal of focus on perceived ‘windows of opportunity’ for their plans to take effect. In the case of the U.S., the electoral calendar and the loss of control of congress in the midterms would seem to be ‘closing’ the window to demonstrate the effectiveness of this trade war. Beijing meanwhile has policy and leadership continuity, so could potentially outlast this U.S. administration.
The Law of Unintended (and Intended) Consequences
The usual motivation for tariffs on end products is to trigger import substitution. Tariffs on intermediate goods make import substitution less likely, because they cloud the calculations. Steel is a great case study: steel tariffs served to help the U.S. domestic steel producers and their steel workers, but this benefit has come at a cost. As soon as the tariffs went on in March 2018, the U.S. steel producers raised their prices to meet the tariff and the foreign producers did not reduce their pricing. In the U.S. auto sector, GM has been a good corporate citizen, historically committed to buying 80% of its steel from U.S. producers. By doing this ‘national service’, GM has been penalised as if it were sourcing 100% of its steel requirements from overseas, pushing up costs by around US$1 billion1 according to market estimates. In October 2018, GM offered voluntary redundancies to 18,000 workers and in November, the company announced its intention to close five North American plants (four of which were in the U.S.).
In a recent study2, Amiti, Redding and Weinstein (2019) found that the impact of the trade war in 2018 has been a complete pass-through of the tariffs into domestic prices of imported goods. Overall, they found that the full incidence of the tariffs fell on US domestic consumers, with a reduction in U.S. real income of U$1.4 billion per month by the end of 2018.
Another study3, by Fajgelbaum, Goldberg, Kennedy & Khandelwal (2019), found that there was an intriguing geographical and political pattern to the trade war. Essentially, the U.S. tariffs were most beneficial in those counties with steelworkers where the Republican Party has not been historically dominant, in states like Michigan, Ohio, Pennsylvania, Wisconsin, whereas the prejudicial impact of foreign retaliation has been disproportionately felt in traditionally Republican counties in Iowa, North & South Dakota and Nebraska, where agriculture is concentrated. Naturally, this impact is a result of careful and deliberate targeting by China and the other countries hit by tariffs on steel and aluminium. The authors conclude that the aggregate welfare loss was US$7.8 billion, but extremely focused geographically.
There is always a trickle-down effect on consumers as goods become more expensive. Industrial policy is not usually helped by tariffs on intermediate goods. If you want to promote manufacturing growth you should keep the cost of intermediates and components low, by putting tariffs on end products, to keep the competition out. By putting tariffs on these intermediate goods, you are obliging your domestic companies to pay more for their intermediate goods; this makes them automatically less competitive on the world stage. Ideally, parts and components should be tariff free.
Preparing the Ground for Corruption?
The World Bank Economist R. Gatti’s, (1999) research4 uses empirical evidence to demonstrate that, across countries, the very existence of a variety of tariffs, diversified by country and product, results in the growth of corruption.
The simplest rationale is the inevitable change in the level of empowerment of customs officials. Logically, the application of different tariffs on products or components means that officials have a menu of tariffs to charge and the importer could potentially be forced into paying a bribe, to avoid having their merchandise erroneously categorised, thus attracting a higher tariff.
If this were to play out, it would result in the cost of the goods rising and the demand for them falling, prejudicing global trade.
Where is the Exit?
China will be motivated to go along with it, recognising the value of the U.S. electoral calendar, alleviating pressure on its own economy and preparing for the inevitable round two in the future.
A Three-Track World
If the trade wars continue at this pace, they may end up dragging others into it, as they retaliate against tariffs imposed on them. This escalation will probably lead to a generalized return to increased state intervention, as voters demand more action from their governments. This interventionist approach will become more widespread, even in countries that have liberal, capitalist traditions, as politicians begin to enjoy having more levers at their disposal. The positive impact will be an acceleration of the adoption and promotion of certain new technologies, but at a higher risk of permanent dislocation of trade routes and long-lasting prejudice to investment returns. Countries that have a long tradition of state intervention will adapt quicker and show benefits in the very short term. Those that don’t will inevitably risk stunting future growth and eroding their institutions if they go too far.
Ultimately, this could lead to three distinct ‘camps’ (‘U.S.-led’, ‘China-led’ and the ‘Old World Order’) each one leading to increasing economic and political interdependency and limiting investment outcomes.
1. The China-led grouping, primarily made up of countries involved in the Belt and Road Initiative and signatories of RCEP5, the Chinese sponsored multilateral trade group. Covering most of Asia and the western Pacific. This group will enjoy continued growth of volumes and value of trade, while becoming ever more closely aligned to Beijing in the geopolitical sphere. On completion, RCEP will be staggering in size and breadth. It covers 3.5 billion people and 33.3% of world GDP, building on WTO rules6.
2. The remnants of the Old World Order, Japan, the EU and some of the Southeast Asian and Pacific countries, via the Japan-EU Economic Partnership Agreement7 and the 11 members of the CPTPP8 (Comprehensive and Progressive Trans Pacific Partnership). The Japan-EU EPA puts the UK at a significant disadvantage post Brexit. It covers 638 million consumers, 28% of the world economy and over a third of world trade. CPTPP accounts for 753 million consumers, 15% of the world economy6 and now places non-members at a clear competitive disadvantage to the members; US companies will now be at a disadvantage to Canadian, Mexican, Japanese and Australian competitors in these markets. Thai, Korean and Taiwan-based firms will lose out to Malaysian, Vietnamese and Japanese competitors.
3. The U.S., which is a relatively less trade intensive economy9 in any case, with a reduced number of non-aligned countries, which become less relevant as trade partners over time, as their ability to compete with technological developments erodes due to their weakening capacity. One candidate for this group is the UK in the event of a ‘hard’ Brexit, where it loses the benefits of cooperation with the EU on technological research but cannot measure up to the U.S. in that field.
Industrial Automation – 5G Value Chain
Artificial Intelligence Firms
How Have Companies Responded?
The Unverified List10
The United Kingdom
At the time of writing, the range of possible outcomes of the Brexit debate remains too wide to justify conclusions on probable end states. Suffice to say that regardless of the position held, investors must see that any outcome that rescinds membership of the EU is less good in trade and economic terms, than before. The rationale is not just limited to the fact that Britain is a middle-sized economy that will be outgunned by larger countries in negotiations, it is that the requirements of other countries for a trade deal with the UK would prove, in my opinion, toxic to the debate. In the case of the U.S., the UK would have to allow direct private sector participation in the NHS (National Health Service), chlorine-washed chicken and GM (genetically modified) crops, all issues that have repeatedly proved to be red lines with the voters. In the case of India, the ask would be visa-free entrance for Indian citizens and free movement of people, which ‘Brexiters’ do not countenance.
Low and Semi-Skilled Humans
Which Countries are on the Danger List?
Countries with Kevlar Jackets
Australia – Security vs Economy
Canada and Mexico – Clause 32.10
Impact on Growth and Investment Returns
Growth projections: global growth is set to moderate in the near term then pick up modestly
UBS has published a research report18 on the impact on economic growth, inflation and financial markets, which finds that world GDP growth could be reduced by 1%, with the pain being taken primarily in the US (-2.45%) and China (-2.3%). Interest rates will suffer more than currencies and all equity markets look set to lose around 20%.
The Australian Productivity Commission has published a report19 concluding that if all countries end up raising tariffs by 15%, global GDP would fall by 2.9%.
For a time, it seems logical to expect, most developed countries will continue to pursue multilateral trade deals, such as the Trans Pacific Partnership, RCEP, Japan-EU and Canada-EU. This would seem to gradually build up a volume of trade (independent of the US), large enough to begin to cushion them from potential tariffs from the US. That could work, until the point where they are forced to choose between camps.
What Can Break this Trajectory?
Emerging Market to Emerging Market trade, however, accounts for 39% of world trade and has been growing at a compound annual rate of 2.9% over last decade. Advanced economies’ trade growth has been pedestrian by comparison at 1.1% in the same period20. Given China’s size, growth and the sheer scale of physical infrastructure built to facilitate trade with the 80+ countries of the Belt and Road Initiative, it seems conservative to expect intra-emerging market trade to overtake developed market trade by 2025.
In this scenario, the separation of the world into three camps will be complete and state intervention will increase as populations become more vocal about their deteriorating living standards, as inflation and higher interest rates fuel inequality. Investors may not be able to maintain their current freewheeling status, as first public-sector plans and then large corporate asset owners find themselves being channelled into restricting exposure to markets in the ‘other’ camps.
Finally, it must be said that all this pain is highly unlikely to achieve a reduction in the U.S.-China trade deficit, or to derail China’s development. Ultimately, a combination of single minded and stable leadership, economies of scale, an increasingly educated population and a dynamic domestic market ensures that Beijing probably accelerates the country’s increasing technological sophistication.
Any information, statement or opinion set forth herein is general in nature, is not directed to or based on the financial situation or needs of any particular investor, and does not constitute, and should not be construed as, investment advice, forecast of future events, a guarantee of future results, or a recommendation with respect to any particular security or investment strategy or type of retirement account. Investors seeking financial advice regarding the appropriateness of investing in any securities or investment strategies should consult their financial professional.
1 Source: GM, Form 10-Q, United States Securities and Exchange Commission.
2 Amiti, Mary, Stephen J. Redding, and David E Weinstein "The Impact of the 2018 Trade War on U.S. Prices and Welfare,” CEPR Discussion Paper 13564, May 2, 2019 http://www.princeton.edu/~reddings/papers/CEPR-DP13564.pdf
3 Pablo Fajgelbaum, Pinelopi Goldberg, Patrick Kennedy, Amit Khandelwal ‘The return to Protectionism’, March 10th, 2019 https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3350407
4 Source: Roberta Gatti (1999), Corruption and Trade Tariffs, or a Case for Uniform Tariffs. Policy Research Working paper, World Bank.http://documents.worldbank.org/curated/en/223751468741371712/pdf/multi-page.pdf
5 RCEP Regional Compr ehensive Economic Partnership is China’s answer to the TPP. There are 16 members: Australia, Brunei, Cambodia, China, India, Indonesia, Japan, Lao, Malaysia, Myanmar, New Zealand, Philippines, Singapore, South Korea, Thailand and Vietnam. Together, they account for $25trn of GDP.
6 Source: Martin Currie, The World Bank.
7 EU-Japan FTA came into force in February 2019, eliminating 90% of customs duties between the countries.
8 CPTPP came into force in December 2018. Members are Canada, Mexico, Peru, Chile, New Zealand, Australia, Brunei, Vietnam, Malaysia, Indonesia, Singapore and Japan.
9 Trade (as measured by imports+exports) represents 25% of US GDP; hence the country is not particularly trade dependent. For China, trade is 36% of GDP. Source: World Bank Database https://wits.worldbank.org/countrystats.aspx
10 Source: US Department of Commerce https://www.govinfo.gov/content/pkg/FR-2019-04-11/pdf/2019-07211.pdf
11 April 10th, 2019.
12 Source: Pakistan Education Statistics 2016 – 7, Ministry of Federal Education and Professional Training, Government of Pakistan.
13 The World Bank’s Human Capital Index measures the amount of human capital that a child born today can expect to attain by age 18, given the risks of poor health and poor education that prevail in the country of birth. Maximum is 1.0. It is designed to highlight how improvements in current health and education outcomes shape the productivity of the next generation of workers, if children born today experience over the next 18 years the educational opportunities and health risks that children in this age range currently face.
14 UNESCO’s definition includes vocational training colleges as well as universities.
15 Source: Australian Government, Department of Foreign Affairs and Trade: https://dfat.gov.au/trade/resources/trade-statistics/trade-in-goods-and-services/Documents/australias-goods-services-bytop-15-partners-2017-18.pdf
16 World Bank database.
17 Source: Source: International Monetary Fund, World Economic Outlook, January 2019.
18 Source: UBS ‘Trade Wars – What is the impact on growth, inflation and the financial markets? A Top Down View', 11 July 2018.
19 'Rising Protectionism: challenges, threats and opportunities for Australia', July 2017.
20 IMF Direction of Trade Statistics database https://data.imf.org/regular.aspx?key=61013712.
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