Weighing US-China trade risk

There are a number of reasons why we remain overweight global equities despite rising trade tensions between the US and China, and a likely increase in market volatility as the Trump administration presses ahead with Chinese tariffs.

20 Aug 2018

Highlights

  • While trade risks between the US and its allies are de-escalating, tensions between the US and China are likely to rise in coming months
  • We expect market volatility to pick up as the Trump administration presses ahead with tariffs
  • Investors should not underestimate growth stabilization outside of the US, including the effects of China’s monetary and fiscal stimulus
  • We remain constructive on global equities, with a keen focus on whether trade disruptions are meaningfully affecting business investment and hiring decisions
  • Hedges for further trade escalation include US duration and short the Chinese yuan and Korean won versus the safe haven Japanese yen

We last wrote on trade tensions in March, when the Trump administration announced its first 25% tariff on USD 50bn worth of Chinese goods as part of its Section 301 investigation into intellectual property. Back then we concluded that while miscalculation was a risk to the economy and markets, ultimately the incentives of Presidents Trump and Xi were sufficiently aligned to avoid a damaging ‘trade war,’ or imposition by both countries of across-the-board tariffs on imports. We make a similar conclusion in this Macro Monthly, except we acknowledge that the stakes have surely risen. President Trump’s initiation of a process to implement tariffs from 10-25% on USD 200bn worth of Chinese goods is credible, in our view. And while less likely, President Trump has also threatened tariffs on auto imports, bringing the administration’s total proposed tariffs to nearly USD 800bn, over a quarter of US imports (Exhibit 1). Considering likely retaliation from trade partners, these are meaningful numbers which deserve careful attention. In this Macro Monthly we discuss how we see trade tensions evolving, their potential impacts on the economy and markets, and considerations for asset allocation.

Erin Browne
Head of Asset Allocation,
Investment Solutions

Evan Brown, CFA
Director
Investment Solutions

Juha Seppala
Director
Investment Solutions


Exhibit 1: US Imports subject to proposed vs. implemented tariffs


Trade policy developments are evolving at a fast pace, though it is not all bad news. NAFTA talks are progressing, with US Trade Representative Robert Lighthizer suggesting it was not unreasonable to have a NAFTA conclusion in August. President Trump and European Commission President Juncker agreed to negotiate tariff reductions between the US and EU, de-escalating trade tensions and lowering the risk of new tariffs. We expect a similar result when Japanese and US officials meet on trade later in August. It is looking as if tariffs on auto imports will be avoided, at least for major US allies.

The recent healing of trade relations between the US and its allies is not a coincidence, in our view. In their press conference last week, Trump and Juncker agreed to work together to reform the WTO. This echoes a recent memo from the European Commission urging modernization of the WTO, with a focus on market access, non-tariff barriers, practices surrounding stateowned enterprises, sustainability objectives, and stricter definitions of which countries count as less developed and therefore eligible for more favorable treatment. While China was not explicitly mentioned in either the EU’s report or the Trump-Juncker press conference, the world’s second largest economy is clearly emerging as the focal target for the transatlantic allies. We should therefore be careful not to extrapolate the sudden easing of trade tensions between the US and Europe as having positive read-through for upcoming US-China trade developments. Rather, the US, Europe and likely other allies look set to unite and isolate China on trade and tech issues, building leverage for what is shaping up to be a prolonged period of tension.

Incentives and constraints for Trump and Xi

President Trump is incentivized to continue pushing China on trade over the coming months. Polls suggest a majority of US voters are skeptical of the benefits of global trade (Exhibit 2) and are generally favorable towards confronting China with tariffs. The outperformance of the US economy and equity markets, energized by fiscal stimulus, emboldens the President to engage further. He has also offered economic support for the agricultural sector, a loser from Chinese retaliation and key voting bloc ahead of the November midterms. On the other hand, the President has arguably prioritized the US economy and jobs above all else. To the extent his policies create genuine damage to markets or the economy, President Trump may feel the need to dial back pressure.

China’s President Xi also has incentives and constraints for further engagement. Having shored up his leadership earlier this year, he does not face the same political pressures as President Trump. Xi may feel he can ride out the US political cycle, prizing Chinese advancement and modernization associated with its Made in China 2025 plan with the clear goal of emerging as a genuine global superpower. Moreover, China has recently taken a number of steps to stimulate the economy, including lowering reserve requirements, increasing liquidity, encouraging lending to small and medium enterprises, cutting taxes and allowing the yuan to weaken. Still, China’s growth engine depends on global trade and a trade war is already disrupting the deleveraging process that China’s leadership views as key to long-term stability.

Given these dynamics, it is of course very difficult to predict how US-China tensions will all play out. At this point we think it’s reasonable to assume that tensions will heighten in the near term as there are still no signs of formal negotiations and the Trump administration is politically incentivized to impose the 10-25%/USD 200bn tariff in September. China’s next move will be key. There is reason to believe China will retaliate but not proportionately; China’s formal response to the initiation of the latest round of US tariffs was less confrontational and specific as it was to the initial USD 50bn announcement. A less than fully proportional retaliation would create some near-term de-escalation, allowing China to appeal to the WTO and setting the stage for a return of bilateral negotiations. But clearly there is a meaningful risk of ongoing tit-for-tat escalation that undermines economic growth and risk sentiment.


Exhibit 2: Perception of trade on wages and jobs


Considering the effects on the economy and markets

Further complicating matters is the difficulty in estimating tariff impacts on economies and asset prices. The direct economic effects of tariffs, such as raising input costs and lowering exports, are unhelpful but manageable. Much more difficult is estimating the indirect effects of tariffs related to supply chain disruption and hits to business sentiment, leading to a potential decline in investment and employment. While global businesses are anecdotally concerned about trade policy uncertainty, we do not yet see hard evidence that it is changing overall business behaviors. OECD business confidence, which leads capital investment, has moderated from all-time highs (from 1975) but stabilized at elevated levels (Exhibit 3). While this generally benign picture can change, we think it’s important to watch the data closely to examine the true disruption caused by tariffs. 


Exhibit 3: OECD business confidence and capex


Indeed, the term ‘trade war’ is used frequently by market participants and in media, but even a worst case scenario should be viewed in historical context. Total proposed tariffs, including on autos which we think as less likely, would bring the US effective tariff rate just above 5% (Exhibit 4). This is a meaningful increase from recent years, but we should be careful not to equate it to 1930s protectionism which exacerbated the Great Depression. We acknowledge that world trade has risen and supply chains have grown much more global and complex over recent decades, but should also take into account that for major economies, trade still represents a relatively small proportion of overall economic growth. Finally, it is important to consider significant stimulus measures, from China in particular, which will help cushion global growth against trade risks.

This is not to minimize the threat of further trade disruption to the global economy and markets. Indeed, we suspect market volatility will pick up from here should the Trump administration dig in as we expect and markets look at potential further escalation from both sides. Nevertheless, our strategy is to wait and see how trade policy evolves with a specific focus on whether this uncertainty is materially impacting plans for investment and employment. Moreover, we have a strong conviction that the administration’s strategy will be reflexive to economic and market impact. Should US equities experience a meaningful drawdown, we expect the Trump administration to dial back pressure on trade to avoid undermining its ultimate priority, the strength of the US economy.


Exhibit 4: Perception of trade on wages and jobs
US effective tariff rate (gross customs duties, as share of total imports)


The bottom line: Asset allocation

We remain overweight global equities despite the expectation of some trade escalation and associated market volatility over coming months. Ex-US growth is showing initial signs of stabilization, which is removing upward pressure on the US dollar. Markets should not underestimate China’s recent pivot back towards stimulus and its implications for global growth and commodities. The combination of a stable dollar, China’s stimulus, still solid global growth and earnings should provide a cushion amid non-negligible trade risks. As we discussed in the last Macro Monthly, valuations for emerging market assets have become much more attractive and are already discounting significant trade escalation. As such we have begun adding EM exposure in some strategies. In fixed income, we maintain neutral exposure to US Treasuries in case trade escalation leads to a flight to quality or a dovish re-pricing of expected Fed tightening. And in FX, we are short the Chinese Yuan and Korean Won and long the safe haven Yen to hedge against further trade disruption.

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