Wealth Management: Strategy blog – US/China trade tensions reignite
Strategy team - Kevin Gardiner and Victor Balfour (Wealth Management)
Only a fortnight ago we were suggesting that markets might have run too far, too quickly - buoyed by improving growth, better-than-expected earnings and receding geopolitical risk.
We spoke too soon.
In the last week, we have seen trade noise return, Iranian tensions flare-up and Theresa May on the precipice (again). Bonds have rallied, equities have fallen, the VIX has spiked and Bitcoin appears to have replaced gold as the safe haven of choice.
But while the geopolitical outlook is less clear than it was previously, these events don't yet suggest an altered investment climate.
As trade negotiations entered what was widely expected to be the final stages last week, a typically unpredictable US administration accused China of "reneging" on various commitments - including making changes to the trade text agreed in earlier rounds of negotiations.
To focus the minds of Beijing's negotiators, the US raised tariffs on $200bn of Chinese goods from 10% to 25% last Friday - following through with a threat from last year. In turn, China has countered with higher tariffs of 25% (10% previously) on $60bn of US goods to take effect from 1st June.
In addition, the US has also suggested that it will raise duties to 25% on the remaining $300bn of Chinese imports that are not subject to Trump's tariffs.
Higher tariffs typically translate to lower growth and higher inflation (and/or reduced corporate profitability). However, to date, the impact appears limited. Growth in the US and China does appear to be slowing, but tariffs likely account for a very small part of this. Inflation - in both producer and consumer prices - has moved higher year-to-date, but this is more likely a function of the higher oil price. If anything, underlying inflation (core CPI) has fallen slightly in recent months. To the extent that tariffs do weaken growth, their long-term impact may well turn out to be deflationary anyway.
In terms of corporate profit margins, these too have been falling but from cyclical highs. In a December blog post we noted that a reversal back to more 'normal' levels was likely as the tax-cut induced boost fades further.
The lack of impact on the US side may lie with the category of goods subject to higher duties - namely intermediate goods and a small number of consumer goods. It is possible that US consumers have been able to adjust supply chains and find alternative substitutes, or simply do without - reflected by the falling tariff revenue in recent months, particularly for more commoditised goods. Perhaps more interesting though is that import prices for manufactured Chinese goods have remained remarkably stable since tariffs rates first increased - it is possible that a weaker renminbi (in 2018) enabled Chinese manufacturers to lower US prices, offsetting higher tariff rates.
In terms of the outlook for the US economy, the new tariffs threatened by China (including earlier tariff hikes) represent almost all of the US exports to China, but these account for just 7% of total US exports or 0.5% of US GDP (likely less now given the collapse in demand for US agricultural products, such as soybeans, to China). Even hawkish estimates of the direct impact suggest this might detract some 0.1-0.3 percentage points from a likely 2.5% growth rate this year.
For China, the position is more concerning. The US is China's single largest trade partner, accounting for over a fifth of its exports (or 4% of GDP). Estimates suggest that this could knock 0.3 to 0.8 percentage points off growth this year, which could double if the scope of tariffs is expanded to cover consumer goods. But even in the face of softer external demand, Beijing still has the monetary and fiscal means to stimulate growth and achieve its (much higher) 6% growth target.
Clearly the risk of a protracted trade conflict has risen. The background has shifted from one of weaker growth at end-2018 to a more stable economic outlook, where perhaps there is less pressure for Xi and Trump to reach a deal. This is most salient for China where unfavourable concessions will slow or possibly even compromise its long-term ambitions ("Made in China 2025").
Meanwhile, we are also anticipating the Commerce Department's 'Section 232' report into auto imports, which is likely to be released this Saturday. Latest reports suggest that Trump may delay any decision for six months, giving Germany and Japan's auto sectors a much-needed reprieve.
Looking ahead, the G20 Summit in Osaka on 28th June marks the next likely meeting between Xi and Trump. Given the high stakes of an all-out conflict, US and Chinese negotiators will be working furtively to reach a permanent settlement.
For the moment, we are still inclined to believe that a constructive outcome is possible and remain positive on growth-related assets such as global stocks - with a preference for emerging Asia and the US, current tensions notwithstanding.
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