Chinese Trade Winds
The Trade winds blow from east to west. That is not going to change. However, depending on which way the China trade talk winds are blowing, the markets are dramatically moving up and down. In January we wrote about our somewhat different take on the “trade war” with China. We questioned whether it was actually a trade war; ……we’re not sure this is a trade war. It may be a war about who will be the global superpower of the future. President Trump may very well be saying “may you live in interesting times” to his good friend President Xi. It’s entirely plausible that the real strategy for the Trump administration is not to reach a trade deal. The U.S. may make the terms of any new deal so unpalatable that this trade war will never be resolved. Here’s our mosaic, perhaps conspiracist, theory; The entire western world, not just the United States, is extremely concerned about China. China has been spending enormous amounts of money to build out their military power. The extremely contentious man-made islands in the South China Sea have now been militarized despite President Xi’s 2015 promise, “no intention to militarize these islands”. Military bases on these islands now have anti-ship and anti-aircraft missiles. It takes money to do this. The Chinese economy must continue to be strong in order for China to pay for their ambitious military agenda. So, while it’s fair for the president to point to unfair trade practices and the impact on U.S. workers since China joined the World Trade organization (WTO) in 2001, Trump’s real agenda may well be to target the Chinese economy. The Chinese economy is weakening much quicker and much more sharply than anticipated……. It’s very reminiscent of how President Reagan took on the Soviets. He bankrupted them. Perhaps we are in more of a cold war than a trade war with China?......... In early 2018, the Trump administration placed a tariff on $50 billion worth of Chinese goods. The president announced that “trade wars are good, and easy to win.” This was the start of what is now referred to as the trade war with China. In May of this year the Trump administration announced more tariffs on $200 billion of imports from China. He then threatened to impose a 25% tariff on the rest of US imports from China. After that, the Trump administration slapped a 10% tariff on another $300 billion of Chinese goods. The latest threat is to place a tariff on all Chinese goods. Regardless of the exact numbers, you get the picture, President Trump wants to completely overhaul our trade relationship with China and is taking a very aggressive approach. In response to tariff threats, China froze agricultural imports from the US and devalued its currency, the Yuan. Stock markets around the world fell sharply. So why would President Trump, whose primary theme for re-election is how he orchestrated “the greatest economic turnaround in U.S. history”, jeopardize economic growth by escalating a trade war with China? Our guess is he doesn’t believe the economic impact of a trade war with China will have a material impact on the U.S. economy. We tend to agree and continue to question the stock market’s obsession with Chinese trade. Nominal GDP in the US is currently $21 trillion. US exports to China are $114 billion. That is only .54% of the total U.S. economy. Assuming the majority of our exports find another foreign destination, we are talking about a minimal, if any, negative change to GDP if China bans our exports.
Meanwhile, US imports (Chinese exports) from China are $522 billion and China’s nominal GDP is $12.4 trillion, about 4.5% of their overall economy. China is an export economy and 20% of their exports are to the U.S. Perhaps more importantly, the US. greatly influences global trade decisions by other countries with China.
So why the market angst? We’ve heard several analysts talk about the inflationary impact of a trade war with China. Forgive us for being cynical, we’ve written frequently about why inflation is not an issue. Globalization and technology allow for supply chains and labor to be quickly moved from country to country or from man to machine. Additionally, it’s likely any inflationary bump from China would be offset to the American consumer by the weaker Yuan.
So, what is the most likely scenario to play out? President Trump wants to be re-elected and President Xi needs economic prosperity to fulfill his vision for his China 2025 agenda. We suspect Xi hopes his status as “President for Life” will give him leverage over Trump’s desire to be re-elected in 2020. We are confident Xi is hoping for a new President come 2020. As the election approaches, if it appears Trump will be re-elected, we expect a new trade deal with China to be agreed upon. If it appears Trump will lose, there likely won’t be a deal until the new administration is installed. What should not be overlooked about the lack of a new trade deal is the economic impact of the trade disputes with China. China’s economic growth is slowing, they have enormous debt, and are experiencing large capital outflows. Last quarter China experienced its slowest growth in over 30 years. We think the market and geopolitical “experts” are missing the forest for the trees. No trade deal does not mean that significant changes in trade have not occurred. The Trump administration is succeeding in forcing manufacturers around the world to move their supply chains out of China. Yardeni Research recently highlighted these three articles supporting this thesis; According to a recent Forbes article, “Make no mistake about it, the trade war is absolutely remapping global supply chains ... to the detriment of Chinese manufacturing. The percentage of China-leaving businesses surveyed by quality control and supply chain auditor QIMA was 80% for American companies and 67% for those based in the European Union. While European companies are less affected by the trade war, they have their own reasons to reduce their dependence on China manufacturing. Most are diversifying throughout Southeast Asia and moving closer to home.” The Nikkei Asian Review says “China scrambles to stem manufacturing exodus as 50 companies leave.” It reported: “China is racing to keep foreign enterprises in-country, dangling special benefits so that the advantages of staying outweigh the heavy tariffs imposed by the U.S. A year into the trade war with Washington, more than 50 global companies, including Apple and Nintendo, have announced or are considering plans to move production out of China, Nikkei research has found. And not just foreign companies. Chinese manufacturers, as well as those from the U.S., Japan and Taiwan, are part of the drain, including makers of personal computers, smartphones and other electronics.” Finally, the Wall Street Journal reports, “Manufacturers Move Supply Chains Out of China.” The observe that: “The moves by U.S. companies add up to a reordering of global manufacturing supply chains as they prepare for an extended period of uneven trade relations. Executives at companies that are moving operations outside China said they expect to keep them that way because of the time and money invested in setting up new facilities and shifting shipping arrangements. Companies said the shifts accelerated after the tariff on many Chinese imports rose to 25% from 10% in May.” This all makes sense. If you are a manufacturing company, why would you set up operations in China? There is far too much risk and uncertainty. Good morning Vietnam, here we come. Trade war or not, the uncertainty and threats of trade with China appear to be achieving the desired results. We lowered the risk profile of the GreenPort portfolios at the end of July. Our reasoning was that although we are still constructive on markets, we anticipate a much higher volatility period. We were also concerned about seasonality factors in our frameworks. If stock markets move lower, we will likely add risk back into the portfolios. We expect this to ultimately be another pullback within the secular Bull Market. Our more immediate concern is about the historically low level of longer-term interest rates.
Our portfolios have been overweight duration, so we have benefitted from lower rates. Fundamentally, rates should not be this low given current inflation levels and historical risk premiums. The challenge is assessing the impact of global rates on U.S. Rates. German and Japanese 10-year yields are negative. Despite a 1.55% U.S. 10-year yield not having appeal to a domestic investor, it’s quite attractive to foreign investors that face negative yields (meaning they actually pay money instead of receive money when they buy their own country’s bonds).
This is attracting foreign money and this demand for U.S. 10 Year Bonds is pushing long-term yields below our short-term yields. This has created the much talked about "inverted" yield curve. We have received several emails asking about our thoughts that the inverted yield curve is signaling that a recession is imminent. Our response has been that the inverted yield curve has successfully called 10 out of the last 5 recessions. What that means is that although it has been a successful forecaster of recessions, it has also given many false positives. The inverted yield curve in and of itself does not cause recessions. What the inverted yield curve is symptomatic of is a tightening of credit and lending. This often leads to a credit crunch which in turn creates the recession. Currently there are no signs that lending is tight and currently consumer spending is booming. We are not dismissing the signal but also not acting on it. We think the inverted curve is due to low international rates pulling the long end of our curve lower, not because credit conditions have tightened. It's a great topic for our next market commentary. Enjoy the craziness, The GreenPort Team