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Here we go again! Trade war and equities

On 1 August, President Trump announced that from 1 September 2019, the US would impose a 10% tariff on the remaining $300 billion worth of Chinese imports not currently subject to tariffs. Beijing responded by allowing the Chinese currency, the RMB, to depreciate sharply - with President Trump branding China as a “currency manipulator”. We recap on the last few days of events.

What happened?

  • On the evening of 1 August President Trump announced that from 1 September 2019, the US would impose a 10% tariff on the remaining $300 billion worth of Chinese imports not currently subject to tariffs. The timing of the announcement surprised financial markets, since a US delegation headed by Treasury Secretary Mnuchin, had just returned from negotiations in Shanghai.
  • Beijing responded by allowing the Chinese currency, the RMB, to depreciate sharply on Monday 5 August. The Peoples Bank of China (PBoC) set the CNY (onshore RMB) to USD fix at 6.9225, above expectations. Reaction to the fix saw USD/CNH (offshore RMB which is seen as more market-driven) jump from 6.98 to as high as 7.11 within 15 minutes. A RMB to USD rate above 7.0 was seen as the red line in the sand for currency stability.
  • Furthermore, Bloomberg reported that the Chinese government has asked its state-owned enterprises to suspend imports of US agricultural products.
  • President Trump responded to the sharp fall in the USD value of the RMB by naming China a “currency manipulator”, the first time such a reference was made by the US government since mid-1990.
  • Equities fell worldwide, albeit after a period of strong performance since the start of 2019. The Dow Jones Industrial Average index fell by 2.90% and the S&P 500 Index fell by 2.98% on Monday. The S&P 500 Index has fallen by 4.56% since the start of August. The ASX 300 Index fell by 2.46% on Tuesday and has declined by 4.94% since the start of August.
  • The US 10 year bond yield plunged by 11 bps to 1.73% on Monday as investors fled to safe haven assets. The Australia 10 year bond yield closed at 1.04% on Tuesday

Comments

  • The naming of China as a currency manipulator is a largely symbolic gesture. Under the relevant US legislation, the US government has to negotiate with a currency manipulator and if the negotiations fail, it has the option to impose tariffs. Given that the US has already imposed and is planning to impose tariffs on virtually all Chinese exports, the move is a moot point from a policy perspective.
  • While a sharp RMB depreciation may seem attractive to Beijing, it may not be effective in shielding Chinese exporters and also carries significant risks. Firstly, this may lead to competitive depreciation by other Asian currencies. Secondly, the US can always counter by imposing higher tariffs on Chinese exports. Thirdly, given the current weakness in Chinese economy, an un-controlled depreciation can lead to significant capital outflows. This is not consistent with China’s goal to internationalise the RMB, ie to have it seen as a reliable globally traded currency.
  • The moves (both by China and the US) over the past few days mean that a 10% tariff on the remaining $300 billion worth of Chinese exports is now the base case. Given the time frame and the recent rhetoric, it is difficult, although not impossible, to envision a way for both parties to de-escalate before 1 September. Someone has to blink - and quickly!
  • How will China react to the new round of tariffs? The trade tensions between US and China have to be interpreted within a broader geopolitical framework. From Beijing’s perspective, China is being confronted by an aggressive containment policy orchestrated by the US. Elements of this containment policy include the United States’ recent arm sale to Taiwan, US war ships sailing through the Taiwan Strait and disputed water in South China Sea, Western support for the pro-democracy movement in Hong Kong, and the technology embargo against Huawei. In short, while Beijing undoubtedly prefers strong economic growth and the associated political stability, President Xi’s response may not be as ’economically rational‘, as suggested by some commentators.
  • The impact of a trade war on risky asset classes is unambiguously negative, but very difficult to quantify. A trade war is essentially stagflationary in nature. Higher tariffs and higher import prices mean higher inflation. A bifurcation of the global supply chain in technology is also highly disruptive. Economic growth will also be lower if the benefits from global trade are reversed. However, there is a high level of uncertainties with any prediction given the personalities and the geopolitics involved.
  • In retrospect, markets have been complacent with the negative impact of a trade war since the G20 Meeting in Osaka. A full scale US-China trade war remains a tail risk, but the possibility has increased and is certainly not trivial! Investors should expect higher level of volatility as markets increasingly price in escalated US-China relationship as the new norm.
  • The saying that “diversification is the only free lunch in investments” again holds true. Generally, fixed interest investments have so far proved to be an effective diversification versus equity.

Written by George Lin, Senior Investment Manager, Colonial First State

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