TRADE WARS, THE TRUMP METHOD AND LIQUIDITY
Equity Markets rose sharply last week as economic indicators and the heightened trade war led investors to conclude that the world economy would slow down marginally in the next six months while the ongoing trade wars would only have a limited systemic impact.
As our readers know, we had been anticipating a break-down in the US equity market as liquidity conditions were tightening but the behavior of the bond market and the flat-to-inverted yield curve is creating an environment of marginally negative real interest rates that remains supportive of equities for now.
In other words, liquidity is clearly prevailing over trade wars for now, and the correction of the first half of the year may be over.
From a fundamental standpoint, what it really means is that as long as bond markets do not break down or the yield curve slope up sharply, monetary conditions will remain. favorable to global equities and emerging markets in particular.
Managing money is about being disciplined and respecting the market’s momentum.
July 2018 started with a bang in that respect.
The second quarter earnings reporting season is starting and earnings should be supportive in the US while the Chinese economy is showing signs of slowing down but the Chinese Government has ample monetary and budgetary ammunition to counter any significant slowdown.
US equities rose by 3 % last week, with the NASDAQ making a new high and the SP500 closing above the key 2’800 level.
Most equity charts are delivering BUY signals and we may be in for a summer rally, until the inflation reality check faces the markets again in the fall.
As anticipated in our recent post BUY CHINA ! the correction in Chinese equities has been halted by the stabilization of the Chinese currency and global investors are no longer worried about the impact of tightening liquidity on emerging markets.
Investors have been piling in Asian and emerging markets again and these markets are giving signs that the correction is probably over for now.
In fact, June 2018 could prove to be a unique entry point into Chinese equities and the Chinese Yuan for the long term.
Investors are rightly wondering what is the ultimate goal of Donald J. Trump in this frontal attack on China.
Clearly, neither himself nor his advisors believe that solution lies in tariffs being imposed on Chinese products imported into the US or on Chinese tariffs imposed on US products imposed on US products sold in China.
China has certainly more to lose economically from a trade war than the US and this is already reflected in the relative performance of the their respective stock markets since the trade war began, but the US will also feel the pain as China’s high market share in many of the targeted products will push a portion of the additional cost onto US firms and consumers.
China’s retaliation measures may not have the same scope in terms of money, but they are striking right at the heart of Donald Trump’s electorate’s jobs, farmers, automobile and aeronautics.
On average, China is the source of nearly a third (29%) of global exports of the products on the $200bn list and around half (57%) of US imports. The $200bn list also includes consumer goods.
This means that more of the tariff burden will fall on US firms that find they have little choice but to continue sourcing many of these goods from China. They will either absorb higher costs in their margins or pass them on.
If they do that for consumer goods, prices will rise for US households. The potential for blowback presumably explains why the US Trade Representative has proposed only a 10% tariff on the additional $200bn list, compared with the 25% rate for the first $50bn.
Going a step further and applying tariffs on all imports from China, as President Trump has threatened, would have even bigger domestic repercussions since it would mean targeting goods for which China is the dominant global supplier. On average, China produces just short of half (44%) of global exports of the products that have not so far been threatened with tariffs and is the source of 70% of US imports of those products.
Clearly, it is not in the US best interest to pursue this kind of trade war, so the ultimate goal is a much more meaningful target.
The Trump Method
To gain a better understanding of what is going on, investors should focus on Game Theory as Mohamad El Erian rightly puts it: A “Reagan Moment” that has an upside that goes beyond tweaks to the existing system by delivering changes in the overall global
economic landscape and terms of trade.
An inherently cooperative game is increasingly played uncooperatively: The Trump administration is taking a disruptive approach to trade, and several other areas, by shaking things up as a means to fix what it views as asymmetrical components that undermine the fairness of the system and harm the U.S.
It has already resorted to disruptive unilateral tactics several times since taking power in January 2017; imposing bans on citizens from the Arab World, threatening to build a wall at the Mexican Border, pulling out of the worldwide COP 21 Agreement, pulling out of NAFTA and the Transpacific Agreement, threatening North Korea militarily, puling out of the Iranian Nuclear accord and now imposing unilateral tariffs on China and Europe.
In game theory terms, the Trump administration has introduced a notable “uncooperative” element to the inherently “cooperative game” that underpinned the rules of international development of the post WW2 era.
Most political experts and economists worry about the implications of the Trumps’ administration actions for the world system as a whole, but the Trump “method” does have some benefits :
It highlights and puts on the table issues that the previous methodology was not capable of changing.
On the international scene, Trumps’ action triggered a historical change in the prospects for peace on the Korean Peninsula, a blocked situation for more than 60 years.
In the Middle East, it brought a systemic change in radical islam and led Saudi Arabia to abandon radical Islam and get closer to Israel so as to solve the Israeli-Palestinian problem. r
For the first time since 1948, Israel and the Arab World have their interests aligned and the prospects for a global solution in the Israeli-Palestinian conflict are greater than ever : concessions on land against massive economic investments in a Palestinian State.
In Iran, he succeeded at isolating the Islamic regime and stopping its expansionary ambitions in the Arab world. He is now suffocating its regime economically in the hope of bringing the first fundamental change since 1979.
On the trade war front, China’s development of the past 40 years was based on an export model that required to keep its labor extremely competitive through an artificially undervalued currency.
For years, China refused to recycle its trade and financial surpluses into its domestic currency and built massive foreign exchange reserves, reaching 40 % of GDP or 4 Trillion US dollars at one point, to be compared to the average 150 Bln of the USA or 10 % of GDP in most developed economies.
China needed to create hundreds of millions of jobs and to bring its vastly rural population into the cities and the secondary and tertiary sectors. This phase is now over and for the past few years, consumption became the leading engine of growth in China, way ahead of exports.
At this stage of its development, China has no option but to change its tack and start recycling its surpluses into its own currency, reducing its foreign exchange reserves and allowing the yuan to rise to increase the relative purchasing power of its consumers and corporations.
This will make China the largest economy of the world much faster than currently predicted.
But the Chinese system of governance is slow and gradual. Change takes much more time than elsewhere and the Chinese administration is all but agile.
His ultimate goal is to force China to accelerate the pace of change, for the benefit of the US indeed, but also of the rest of the world and of China itself.
In his youth, Donald Trump was a vocal opponent of the Japanese product invasion in the 1980s when the Yen was, as the yuan today, artificially undervalued. The Japanese Yen ended up appreciating form 360 to 110 in less than five years between 1982 and 1987.
Now that Donald Trump is President of the most powerful nation on the planet, he is applying the same to China.
The strategy is not without risks however;
Trade wars tend to create a strong stagflationary impulse, disrupting growth and increasing costs and prices. The conflicts complicate domestic policy management and increase the risk of
financial instability. They also risk causing serious fractures to the international economic and financial architecture, with consequences that can extend well beyond economics and finance.
Until now, the markets have rightly attached a considerably higher probability to a positive outcome, but like in every Game theory plays, the ultimate result could end up much worse than initially expected.
Further escalation is the most likely outcome in the short term:
For trade tensions to be a means to a better end, individual country behaviors must change in a manner that is visible, verifiable and durable.
This is particularly true of China’s approach to exchange rates, intellectual property, market access limits and joint venture requirements, which are a longstanding source of friction with the U.S., as well as other countries.
Until there are indications of durable change, the most likely American strategy will be to increase the pressure on China, even though that carries significant risks for all.
The U.S. stance is intended to leave no doubt about the administration’s resolve and its commitment to affecting change, almost regardless of the domestic costs.
But the U.S. could end up pushing China too far,too fast. That would threaten not just a full-blown trade war,but also increased geopolitical strains and financial disruptions including the fact that China is a large holder of U.S. government securities and a major participant in the dollar market
The game is inherently unbalanced:
Whether by accident or design, the U.S. is now playing in an uncooperative game that it is well placed to win in relative terms.
In truth, the US administration’s strategy is on the side of structural trends inherent to China’s own development and the Chinese know that full well. Moreover, despite their slow and gradualist culture, the Chinese are also pragmatic by nature and philosophy.
They are currently taking the measure of the fact that the world ( or the US ) is no longer willing to accept the state of affairs and that the ball is in their camp.
The situation resembles the 1980s, when President Ronald Reagan embarked on a military spending race with the Soviet Union, a contest America was destined to win, albeit with costs and at considerable risk. It ultimately led to the fall of the Soviet communist regime.
This is an approach the Trump administration will be tempted to press further when it shifts its attention back to the modernization of existing trading arrangements with other countries, including some of its closest allies.
China will likely ultimately agree to some U.S. requests: Because the game
is unbalanced, China’s least costly strategy over time will be to seek a return to a cooperative approach to trade, even though the country is making gains on regional arrangements.
Moreover, the current stand-off may also help Xi JingPing himself. The great reformer is battling significant behind-the-scene battles with the conservative factions of the Chinese communist Party and the administration and Donald Trump’s pressure may be a highly needed catalyst to force change inside the Communist Party itself.
The current batch of Public accusations and counter-accusations make trust difficult and China, of all, is extremely sensitive to “face”
Restoring greater trust between China and the U.S. is key to re-establishing a durable cooperative game. This requires behind-closed-door meetings that set aside accusations currently being levied by both sides, and focus on immediate confidence-gaining steps as well a framework for resolving the inevitable misunderstandings and misperceptions that are likely to arise.
The sooner these meetings resume in earnest, the lower the risks the current uncooperative game will turn into a very costly global trade war.
In fact, when analyzed coldly and objectively, Donald Trump’s strategy is the only one that can ultimately force the Chinese to accelerate a structural change that is inevitable but that the Chinese wanted to manage gradually.
The question then becomes:
Can China make a significant move and end the trade war without losing face ?
Probably yes, and this will probably come from announcing a different strategy on foreign exchange, the only thing thing that the US administration has never asked for publicly but is the only way to reduce visibly the trade deficit of the US with China.
It is also the one policy that can be sold domestically in a positive way and for domestic reasons.
This will take a few months though and may have to wait for the next meeting of the Chinese Standing Committee meeting in October.
But to us, this is a sign that investors should start accumulating the Chinese Yuan bef0re a major structural appreciation phase starts.
The current levels of the Yuan may never be seen again.
In the past few months, inflation has risen globally much faster than interest rates. In most economies, the CPI is now at or above the highly publicized 2 % target of most western central banks, but monetary policies remain hugely accommodative.
In the US the pace of interest rate normalization is still very gradual and real interest rates are still marginally negative. In Japan, Europe, Switzerland and the UK, interest rates are kept at zero or close to zero while inflation has shot up significantly.
Short term and long term REAL interest rates are becoming increasingly negative, fueling massive liquidity injection.
In Europe and Japan, bond investors are actually paying to lend money to borrowers.
Yield curves are their flattest since 2008 in most developed economies, a development usually interpreted as signalling an economic downturn.
The difference between yields on 10-year and 2-year government bonds has fallen to its lowest level since 2007 in the US and Canada.
If the recent pace of flattening is sustained, both curves are on track to invert by the end of this year; i.e. for the ten- year yield to fall below the two-year yield. The gap between ten- and two-year yields is just 0.2%-pts in Japan, and is near its post-crisis low in the UK.
Yield curves are generally thought to be leading indicators, and inversions to be leading indicators of an upcoming recession.
Therefore, on the face of it, the flattening yield curves suggest that there is a growing risk of a recession involving several major advanced economies taking place in the next couple of years.
Given that global monetary conditions are set to tighten and that the trade war looks likely to intensify, the possibility of a recession is not completely remote. Moreover, the base effect of the tax incentive is bound to fade away. One can certainly not exclude a mild recession in 2020, particularly if equity markets break to the downside.
However, as we have argued before, the yield curve is not the crystal ball it is often made out to be. For one thing, outside of the US and to some extent Canada, it has a weak relationship with GDP growth and inversions are considerably worse at “predicting” recessions.
Moreover, inversions often give misleading signals. There have been many cases when an inversion has not been followed by a recession, because yield curves are influenced by factors other than pure expectations about the economic outlook.
To us, the current flat or inverted yield curves seen in the US, Canada, the UK and parts of Europe have all to do with the fact that investors do not yet believe in the return of inflation in any sustainable way.
After 30 years of disinflationary trends and even outright deflation, investors, and central bankers, have spent most of their professional lives in a disinflationary environment and have forgotten what inflation is : a self-feeding process.
Economists know full well what we are talking about, their own process is all about looking into the rear mirror to predict future trends. And Central Bankers got very scared of deflation in the past 10 years, so they are prepared to err on the dovish side to avoid a fall back into deflation.
However, most inflation gauges around the world are now at or above the well-publicized central banks target of 2 %.
Wage pressures are still low despite the tightest labor markets in 40 years in the US and other major economies, but when compared to the past cycles, this is mainly due to the impact of the internet revolution.
It does not mean that wage pressures are not going to develop in the future, but just that it may take a little bit more time than in previous cycles.
An interesting feature of the latest US job market data was the number of new entrants into the labor market. More and more people who had stopped looking for jobs are coming back as job offers and salaries are strong. But this phenomenon is limited in scope and when the wave of new entrants is exhausted, then wages will accelerate upwards.
Capacity utilization is back to its long term average of 80 % and history shows that when it crosses that threshold, inflation starts developing again.
Investments are still strong in the US and companies are expanding at the fastest pace in a decade, encouraged by low interest rates, high corporate profits and strong operational cash flows.
When it comes to bond markets, fixed income investors are convinced that inflation will be contained by the Central Banks in the future and are not pricing any premium into bond yields.
History tells us that they will probably be proven wrong.
Central Banks are way behind the curve and their artificial handling of bond markets is making things even worse.
Once inflation gets our of hand and accelerate, taming it is extremely difficult and requires much, much higher interest rates.
Moreover, if China bows to international pressure and finally allows its currency to rise, the global cost of labor will increase and the labor markets of the western world will become even tighter.
In other words, the key variable to watch for investors is US inflation numbers. Any acceleration of inflation over several months will start changing investors’ psychology and make them accept the fact the current inflation is not a passing phenomenon.
When investors finally realize that inflation is here for good and does not peak, then bond markets will correct sharply and equity markets will follow suit.
This occurence has probably been pushed back to the fall.
ONLY A BREAK DOWN IN BONDS WILL SIGNAL THE BEGINNING OF THE EQUITY BEAR MARKET.
Also published on Medium.