The economics of the US-China trade tensions

CIO Global Blog

05 Jun 2019

The nascent optimism about growth in emerging economies, led by China, has again been clouded by the sudden escalation of US-China trade tensions. Our baseline scenario foresees some kind of agreement over our six-month tactical horizon, but we still expect lower growth and more policy stimulus in China. Other emerging economies will also be negatively affected, but we don’t expect growth to deteriorate significantly. We favor smart carry strategies in this environment.

China: Lower growth, more stimulus

The US upped the ante in its continuing trade conflict with China by increasing its tariffs from 10% to 25% on USD 200bn of Chinese imports. It also threatens to impose additional tariffs of 25% on the remaining USD 300bn worth of Chinese goods it buys. In our base case, we expect a trade deal or truce over the next six months, though only after a bumpy negotiation process. With new tariffs already in place and uncertainty running high, we downgraded our growth outlook for the Chinese economy from 6.4% to 6.2% for 2019.

The renewed trade tensions come at a time when Chinese economic data failed to live up to the good March readings and the better-than-expected 1Q19 GDP. Official manufacturing PMIs receded to levels just above 50 in April and dropped below 50 in May; exports contracted in April compared to a year ago; and urban investments, industrial production, and retail sales growth in April came in weaker than expected. With the added weight of tariffs, China is likely to shift its policy bias in favor of easing again. The People’s Bank of China (PBoC) may ease liquidity conditions through various channels. The central bank said last month that to ensure ample liquidity in the banking system, it had offered CNY 200bn of medium-term lending facility and CNY 25.6bn of standing lending facility. Fiscal policy will likely become more expansive as well, with measures to stimulate consumption, speed up infrastructure spending, or further ease credit. This should help keep China's economic growth running above 6%, despite the trade headwinds.

The situation changes if the US imposes the full suite of tariffs and the escalation goes beyond the scope of trade. Even with additional stimulus, Chinese GDP growth would likely fall below 6%. We assume a roughly 1-percentage-point decline in growth, with some uncertainty with regards to the potential multiplier impact on consumption and investment.

Other emerging markets: Affected by direct and indirect channels

A weaker China does not bode well for other emerging economies, specifically for export-driven countries with strong trade links to China, such as South Korea. Last year, the Korean economy grew 2.7%, the slowest pace in six years, marked by a decline in exports led mainly by semiconductors and other China-bound shipments. The fresh escalation of US-China trade tensions will also likely be felt by other export-oriented Asian economies that had shown signs of improvement toward the end of 1Q19. Accordingly, we have lowered our 2019 GDP forecasts for some economies, including Taiwan and Singapore.

Meanwhile, commodity exporters will feel the pinch if China’s hunger for raw materials weakens. And even among economies that have no meaningful direct links to China, softer risk sentiment could expose the externally vulnerable ones with high current account deficits or weak budget balances, or those that are highly dependent on portfolio inflows. Some of China's stimulus may find its way into other emerging markets, but at this point we only expect marginal effects given its likely more domestic focus.

Investment implications: Look for carry amid uncertainty

What does this all mean for investors? An all-out trade war could trigger the end of the global growth cycle. Luckily, we’re not there yet, and we expect cooler heads to prevail in the end. In the meantime, moderate global growth, combined with the readiness of policymakers to step in when needed, favors smart carry trades, in our view. One such trade is our newly introduced basket of high-yielding emerging market currencies against a basket of low-yielding, high-beta currencies.

Winning losers

On a macro level, everybody loses from restrictions to trade. On a micro level, some may benefit. Recent reports and surveys show that some companies are already shifting their supply chains in response to the trade tensions. High-value-added products tend to relocate from China to Taiwan or Korea, while lower-value-added ones are more likely to move to Southeast Asia. The trade conflict, therefore, would probably only accelerate the already existing trend of migrating low-value manufacturing to China’s neighbors, while also reinforcing China’s goal to focus on more sophisticated production. Apart from Asia, other countries and companies may be able to book small wins, namely those that serve as a substitute supplier of goods. Mexico seemed like a potential winner, until President Trump unexpectedly announced tariffs on all Mexican exports to the US. This serves as a warning to not base investment decisions on the fickle politics of trade alone, but look for opportunities with beneficial structural or economic dynamics, apart from trade.

Fig. 1: Latest Chinese data have not sustained recent gains

Industrial production, retail sales, urban investment, and GDP growth (in % y/y)

Source: Bloomberg, UBS, as of 24 May 2019

Fig. 2: Trade connects, in good and bad times

Export and import growth for China, South Korea, and Taiwan (in % y/y, 3-month moving average)

Source: Bloomberg, UBS, as of 24 May 2019

Author:

Tilmann Kolb, Analyst, UBS Switzerland AG; Xingchen Yu, Emerging Markets Strategist Americas, UBS Financial Services Inc. (UBS FS)