Reading the runes of the trade wars

China’s actions with regard to the tariffs so far may provide a model for reciprocal actions going forward. This obviously only works up to a certain point – China imports only USD130bn of US goods, while the US buys more than USD500bn from China1. We believe the Chinese will recognise that, while Trump may have the upper hand, time is on their side. The nearer we come to US midterm elections in November, the more likely it is that Trump will be seeking a face-saving solution.

24 JULY 2018

Many hedge funds will want to forget the third week of June, 2018. The industry endured a period – seemingly more frequent now than in the past – where we felt the inescapable interconnectedness of markets and, particularly, the way that the machines that handle so much of the day-to-day volume of trades can prolong and magnify episodes of volatility. Until this point, there had been a guardedly optimistic tone to most funds’ positioning, with the expectation being that any US-China trade war would turn out to be nothing more than political posturing and concerns about slowing growth and problems in Brazil and Turkey would be overridden by animal spirits and the onward march of technology. A popular trade among US hedge funds was being long cyclicals – which benefit in the event of positive economic momentum – and short retail – with the view being that Amazon2 is in the process of undermining most traditional retailers’ business models.

All it took, though, was for someone to blink first. The significant market moves of that third week in June were driven by some initial repositioning that drove most of the market to follow suit. An investor or group of investors decided that, with the formal instigation of the US/China trade war approaching, the positivity expressed by the long-cyclicals/short-retail trade was perhaps overly sanguine. The investors began to cover their retail shorts, the machines spotted this and, driven by their strict risk management limits, executed trades that increased the pressure on those that were slow to move. It was a difficult week for many, exacerbated for some by redemptions which drove further selling and repositioning.

What this painful episode brought home to us was just how desperate the market is for direction just now, and how challenging it is to express views in a world where conviction rests on such unsteady ground. Although the beginning of the trade wars on 6 July drew little reaction from the markets, with the information already priced in, the Trump administration’s announcement on 11 July, only a few days into official hostilities, that they were considering a further 10% levy on USD200bn of Chinese goods pushed markets down across the globe. What everyone has been looking for is clarity on how aggressively President Trump will pursue his trade wars, even in the face of market resistance, and it is thought by many that this follow-up move may signal a more antagonistic stance than previously expected.

It’s unclear at this point how China will respond to a trade war it didn’t want and is entering into reluctantly – there was a slightly comic moment when Chinese officials realised that, due to time zone differences, there was a risk that they could initiate tariffs before the Americans. As a result, the government ordered its customs officers to hold off for 24 hours, so as not to be seen to fire the first shot.

There still appears to be little consensus as to the duration and impact of the trade wars. The most lucid account we’ve seen came from Treasury Secretary Steve Mnuchin’s alma mater Goldman Sachs (‘GS’), whose economists put out a comprehensive research note1 on the potential impact of a trade war. They looked at both the impact of the measures already introduced – the USD34bn of reciprocal tariffs implemented on 6 July (which is a subset of the USD50bn announced in March) as well as duties on washing machines, solar panels, steel and aluminium. They also looked at those tariffs that have been threatened by the Trump administration – 25% on an additional USD100bn from China, 20% on USD275bn of automobile imports and then a further 10% on an additional USD300bn from China (of which the USD200bn threatened on July 11 would be a part). If all of these moves were to be put in place, then it would raise the total scope of US tariffs to USD800bn.

Figure 1. Total US imports affected

Source: USITC, Goldman Sachs Global Investment Research.

The initial findings of the GS report were comforting. Working on information available at the end of June, the bank’s economists calculated that the impact of the tariffs on the growth of the economies implicated. In their calculations, they assumed that the China’s actions with regard to the tariffs so far provides a model for reciprocal actions going forward, so that we should expect tariffs imposed by the US to be met with retribution of a like kind. This obviously only works up to a certain point – China imports only USD130bn of US goods, while the US buys more than USD500bn from China – but it’s a good starting point. As such, it was calculated that the trade war would shave a mere 0.1% from US growth, with the impact on other implicated economies similarly muted.

Figure 2. International real GDP effects from tariffs after 3 years are modest

Source: Goldman Sachs Global Investment Research.

It was only towards the end of the research note, when the economists began to speculate about possible further ramifications from the trade war that the picture becomes more bleak. While China does not have the ability to reciprocate fully against US tariffs given the trade balance, there are significant other retaliatory measures that could be taken by the Chinese government. These include depreciating the renminbi and selling down holdings in US treasuries. Already, the Chinese currency has been clearly depreciating, with July’s surprise tariff news prompting a move through the 6.7 mark against the dollar.

Figure 3. Chinese currency has been depreciating

Source: Bloomberg as of 11 July 2018.

In the pessimistic scenario that the Goldman Sachs note posited, the impact on the global economy was more marked, with global GDP hit by 0.4% and with Europe, the UK and Canada suffering most. The US and China would be left in a similar position under this model, experiencing around 0.5% of negative GDP growth.

It will be interesting to see how pronounced the market reaction to the 11 July announcement is. Commerce Secretary Wilbur Ross declared at the end of June that the trade war would continue notwithstanding any negative stock market reaction. “There's no bright line level of the stock market that's going to change policy,” he said. “[President Trump] is trying to fix long-term problems that should have been fixed a long time ago.” It could be that the current more aggressive tone from the administration is driven by the fact that the midterm elections in the US, which take place in November, are moving ever nearer, and, for all the bravado of Secretary Ross’s pronouncements, the President will not wish to go into midterms with stock markets tanking and a faltering economy. If this is not the case, and it becomes clear that we are moving into a new phase of global economic history which will be dominated by protectionism, then we should expect a dramatic repricing of the markets, something that will be particularly painful as we move through traditional summer illiquidity.

Figure 4. The effect on real GDP after 3 years on Chinese retailiation

Source: Goldman Sachs Global Investment Research.

What Trump is looking for here is a headline win in the next few months similar to that achieved in the North Korea talks. What a win would look like is unclear at this point, but we believe that the Chinese will recognise that, while Trump may have the upper hand, time is on their side. The nearer we come to November, the more likely it is that Trump will be seeking a face-saving solution.

We believe it’s important, though, not to lose sight of the longer-term consequences of the trade wars, above and beyond any potential near-term implications for the markets. It may be that, looking back on this febrile moment in geopolitical-economic history, we view the tariffs as part of a broader narrative: that of the gradual reflation of the global economy in the wake of years of artificial suppression. One of the consequences of QE was that it rewarded the holders of financial assets to the detriment of wage-earners. We believe the inflation that could be associated with any prolonged period of protectionism may end up contributing to a reversal of that equation, potentially providing workers with some (sorely needed) increases in their wage packets even as it penalises their employers and the investors in the firms for whom they work.

 

1. Global Economics Analyst, ‘The Trade War: An Update’, Goldman Sachs Economics Research, 25 June 2018.
2. The organisations and/or financial instruments mentioned are for reference purposes only. The content of this material should not be construed as a recommendation for their purchase or sale.

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