U.S. – China Trade: The Challenge

U.S. – China Trade: The Challenge

Rather than intently watching both countries volley retaliatory measures, we think it’s more valuable to look at local-currency valuations and trends in China’s interest rates.


President Donald Trump’s show of force at the G7 summit, his historic handshake with Supreme Leader Kim Jong-un, and the temporary calm amidst his ongoing trade conflict with China are such fleeting details for investors to follow. Trump’s flip-flop tweets add further uncertainty to the geopolitical situation.

Rather than intently watching both countries volley retaliatory measures, we think it’s more valuable to look at local-currency valuations and trends in China’s interest rates. Of course, the future of trade will have an impact on the financial conditions of both countries.

The Fragile and Short-Lived Trade Truce

Markets reacted positively in late May to the joint statement issued after the U.S. delegation’s trip to China. On the surface, it definitely eased tension after rounds of tariff threats and sanctions.

The First Gunshot of the Trade War

The trade truce was very short lived. Fast forward to June 15, when the trade war seemed to resume and potentially escalate. However, this saga might not have a quick and happy ending so easily. In our opinion, there could be long, drawn-out disagreements between the two countries, in three phases:

  1. A near-term trade scuffle
  2. A medium-term technology competition
  3. A long-term strategic rivalry

With the continuous negotiation between U.S. and North Korea adding another layer of uncertainty and complexity to the trade negotiation, we don’t think a tariff imposition is necessary -- as China has extended an olive branch by offering to purchase $70bn of goods including autos and food, on the condition the U.S. abstains from imposing tariffs. Furthermore, China has cut tariffs on auto imports from 25% to 15% and taken some other various measures to open financial market access, such as removing the lock-in period and repatriation restriction for both Qualified Foreign Institutional Investors (QFII) and renminbi QFII (RQFII) program. Onshore currency hedging permission is also granted. Due to this market access, portfolio inflows into China’s onshore bond and stock market have partially offset the narrowing current account surplus.

If China shifted its import source from other trading partners to the U.S., the countries that currently rank as top partners could be negatively affected:

 

Source: CFIC, Morgan Stanley Research. Note: Numbers represent share of the country in China's imports by sector. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

Why the Sudden Change?

The sudden about-face by the U.S. from the temporary trade truce to the imposition of 25% tariff on $50bn of Chinese exports has three implications:

1.   There is disagreement between the dovish Secretary of Treasury Steven Mnuchin and hawkish members of the administration like the president’s economic advisers, Robert Lighthizer and Peter Navarro. The debate centers on whether a quick win on trade before the U.S. mid-term elections or a tough stance demanding structural adjustment from China’s industrial policy is a politically advantageous solution. Both sides of the presidential administration are competing to win over Trump and jockey for his influence. This dichotomy illustrates the fickle nature of this trade negotiation and the internal contention with the president’s own cabinet. Therefore, China—as well as other U.S. trading partners—could reasonably conclude that anything agreed upon with the U.S. could be pulled back later.

2.   This sudden change also runs parallel to the tariff that Trump has imposed on his allies like Canada and the European Union (EU). He can’t afford to be tough on allies and soft on China. So if China turns out to be not an isolated case, this may turn into a global trade war.

3.   The trade conflict will mostly intensify given the mid-term Congressional election is coming. Trump needs to appease his base whereas the issues from China’s side appear to be smaller. In our opinion, not until a new trade equilibrium is reached might we see escalations and the eruption of a tariff war. Therefore, we now expect a temporarily calm intermission from behind-the-scenes negotiations that will bubble up into more retaliatory rhetoric and policymaking.
 

A Snapshot of China’s Economic Health

Despite the trade war noise, China’s latest import and export activities have been quite robust, driven still by global growth, front-loading exports due to trade conflict and strong domestic demand via consumption. China’s total trade surplus kept narrowing, but not with the U.S., indicating the trade imbalance is not an easy fix through administrative policies.

 

Source: Brandywine Global, Haver Analytics. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

The direct impact from the above tariffs on gross domestic product (GDP) growth is very small, given China’s exports to the U.S. is in the magnitude of $500 billion. However, they could be disruptive to the global supply chain and they can be read as a sign of ratcheting up trade tensions. $50bn could be the first tranche of potentially larger tariff coverage. Mutual investments between the two countries could be negatively impacted as well. American multinationals with footprints in China are now bracing for a harsher operational environment. Consumers in both countries would endure more pain and potential price inflation. Furthermore, the review of China’s ZTE Corporation—which faces U.S. Congressional sanctions—currently favors penalties as opposed to an outright ban, and may improve the chance of a trade deal between U.S. and China. However, the final verdict is still up in the air.
 

What Really Matters, At Least to Us

The ongoing uncertainty with respect to trade, technology competition, and the strategic rivalry between the

U.S. and China has become the new normal. It is unavoidable due to the rise of China and its vastly different social system. The perception that the trade conflict can be easily resolved is probably naïve. One thing is certain: there are ebbs and flows with varying intensities. The big question for investors is the future direction of renminbi and China rates. The Federal Reserve (Fed) hiked rates in June, whereas the People’s Bank of China (PBoC) did not follow suit as it appears to be concerned with exogenous shocks from an incipient trade war. As the chart below shows, the narrowing gap between China onshore rates versus U.S. rates exerts downward pressure on renminbi versus the dollar.

 

Source: Brandywine Global, Haver Analytics. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

China’s renminbi has been strengthening against both the dollar and the basket of currencies (CFETS) since 2017, and reversed starting in April 2018 due to the acceleration of dollar strength as a result of China’s reserve requirement ratio (RRR) cut. The renminbi’s next move could depend on the dollar; if the dollar strengthens from here, the renminbi’s rally against the basket of currencies could decelerate. If the dollar weakens from here, the renminbi would have the luxury of moderate weakening to ease monetary conditions.

China’s foreign reserves declined slightly recently. Given the uncertainty of external trade negotiations and burgeoning corporate defaults, China will ensure domestic stability and support growth through moderate easing of monetary conditions or fiscal support. Markets expect that more RRR cuts could be on the horizon to relieve a potential liquidity squeeze or a slowdown due to external pressure. This relatively easy policy should portend better performance of Chinese assets, including equities and onshore bonds.

 


Definition:

The China Foreign Exchange Trade System (CFETS) provides financial services. The Company offers trading, information, and benchmark services as well as training facilities to the interbank lending, bond, and foreign exchange markets. CFETS serves customers throughout the world.  

 

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