Graham McDevitt, Senior Portfolio Manager, Macquarie Fixed Income
Thursday 19 April 2018
Trade: the good, the bad, and the ugly
Graham McDevitt, Senior Portfolio Manager, Macquarie Fixed Income
We are not in a trade war with China, that war was lost many years ago by the foolish, or incompetent, people who represented the US. Now we have a trade deficit of $500 billion a year, with Intellectual Property Theft of another $300 billion. We cannot let this continue!
The risk of a trade war between the US and China has grabbed markets’ attention in recent weeks, fuelled by headlines such as illustrated above, but also because of the threat of retaliatory action from China. Equity markets are under pressure, credit spreads are wider and bond yields lower as a result. Consensus is that the US and China are in the midst of a noisy negotiation process that (surely) will end at the negotiation table with a sensible solution.
Economists scream ‘no one wins in a trade war’
The argument for free trade is based on the theory of comparative advantage, ascribed to 19th century economist David Ricardo.
Comparative advantage can be described as the ability of a country to carry out a particular economic activity more efficiently than another country. The theory states that if countries specialise in producing goods where they have the lower opportunity cost, there will be an increase in economic welfare – that is, both countries will gain by trading with each other.
So the good news is that with the cyclical upswing in growth in 2017, global trade expanded, assisting a synchronised acceleration of growth.
Chart 1: Growth and global trade
The US-China trade deficit
So, why is there a problem?
Chart 2 below shows that the trading relationship between the US and China has moved from near zero to a deficit of $US375 billion over the past 20 years.
President Trump wants to reduce this deficit, and has planned to implement tariffs (a levy/tax on a specified item of import) against certain Chinese imports. The US argues that Chinese companies sell their products at lower prices in foreign markets than they do at home – a practice known as ‘dumping’. In addition, the US claims that China is stealing intellectual property despite the practice having been tolerated since China entered the World Trade Organisation.
Chart 2: US-China trade deficit – from near zero to $US375 billion
Source: U.S. Census Bureau
A trade deficit happens when a country imports more than it exports. What these numbers do not show is that if US goods are sent to China for assembly and then returned to the US, these so-called ‘intermediate goods’ are considered Chinese imports, even if the parts are made in the US. Oxford Economics and the US-China Business Council suggests that if the data were adjusted for intermediate goods, the deficit would be cut in half.
So why are economists so concerned?
Back in the late 1920’s the construct of what would eventually become the Smoot-Hawley Tariff Act was conceived against a background of a strong US economy and low unemployment. By the time it was passed in 1930, the world had slumped into recession and the ensuing trade war made a dire situation worse. There is no suggestion of a direct parallel between today and the 1930’s, but the warnings signs suggest that an escalation of trade conflict can have wide ranging implications for prices, production and demand, and therefore global growth.
Why does this matter for financial markets?
Experience reveals that President Trump does not always follow through on everything he says or tweets.
Market consensus has been relaxed about the threats on trade, even when the White House followed through by imposing a 25% tariff on steel imports and 10% on aluminium on 1 March 2018. It was only when Gary Cohn resigned on 6 March that markets began to take the trade risk seriously, as this implied the hard line adviser Peter Navarro was winning the battle in the White House on trade.
US business concern rose when China announced measures targeting US exports of aircraft, soybeans and other products, threatening to bring on a tit-for-tat trade war of escalating sanctions between the world's two biggest economies.
Equity markets were already off to a shaky start in 2018, as fears of higher interest rates in the US began to escalate as the US passed its tax cuts and wages growth edged higher. This price action ignited a surge in volatility, which has remained elevated, after a prolonged period of below average volatility as illustrated by the Chicago Board Options Exchange Volatility Index (VIX).
Chart 3: Historical VIX
Interestingly, US bond yields were slow to respond to the escalating trade tensions, and the rally in recent weeks is still modest in comparison to prior risk-off situations. This in part reflects the bond markets focus on Federal Reserve policy (where another rate hike was delivered in January) and fear that inflation will rise in coming months.
Chart 4: Historical US 10 year Treasury yields
However, US growth was supposed to be soaring in the wake of the tax cuts. The retail sales data suggest consumers front ran this phenomena in the fourth quarter of 2017. Many economists are shrugging this off, suggesting the growth pulse will strengthen in subsequent quarters.
Non consensus and looking for balance
The short-term economic cycle accelerated in 2017 and expectations were for this to be sustained in 2018. While we agreed with this consensus, our outlook for 2018 was more reserved mainly due to strong structural headwinds:
- demographics with the economic implications of an aging population
- too much debt
- the dependencies on low yield
- the risk of de-globalisation with the rise of populism.
Our analysis guided that the mix of cyclical and structural in 2018 should not result in too much inflation risk, and also that the low volatility environment of 2017 would be unlikely to repeat in 2018.
This view lead us to our current positioning. We remain overweight credit risk as bottom up fundamentals are strongly supportive. As a balance, our lack of fear of inflation and belief that volatility will remain leads us to continue our non-consensus strategy of opportunistically adding duration.
As we enter the second quarter markets are delicately balanced: is this a temporary correction or the start of a more substantive sell-off? In this context, we will continue to act to balance our Funds with a core belief of prioritising protecting our investors’ capital over the search for yield.
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