Jason Todd, CFA, and the Investment Team
Friday 24 August 2018
Trump, Trade wars, Trouble
Jason Todd, CFA, and the Investment Team
- Direct economic impacts from an escalation in trade wars will be minor compared to the wounds inflicted on relationships with allies and trading partners;
- Free trade has been in decline for a decade. Non-tariff protectionary measures by World Trade Organization (WTO) members has doubled since 2009. The shift towards rising protectionism, regionalism and nationalism is a structural shift;
- President Trump is unpredictable but his trade policy stance has been an area of consistency (viewing many trade partners as cheaters). Upcoming mid-term elections provide a strong incentive for the further pursuit of “America First”.
- Secondary transmission channels via global supply chains have the potential to substantially amplify negative drags from tariffs even if the nominal amounts are low. Greater market volatility as well as a hit to consumer and business confidence are inevitable the more prolonged trade ructions become. The consensus view is that trade wars will be inflationary. The tail risk is that they are recessionary and hence deflationary.
- Economically, Australia is relatively insulated from direct trade war impacts. However, the A$ is linked to China and a rising risk premium is likely to see it track lower through 2H. The outlook for commodities deteriorates under a trade war escalation but the off-shoot could be further monetary and fiscal easing by the Chinese.
- Global policy tightening combined with rising trade uncertainty are headwinds for markets to push meaningfully higher. Our asset allocation has become more defensive in recent months. At a stock level we stick with quality growth names including: Aristocrat (ALL), Boral (BLD), BHP Billiton (BHP), CSL, Cochlear (COH), James Hardie (JHX), oOh Media (OML) and Reliance Worldwide (RWC).
Global trade war fears remain heightened ahead of a resumption of trade talks this month. The US is trying to strong arm China in relation to its Industrial policies (in particular concerns around intellectual property theft and its China 2025 plan which aims to create a number of globally competitive players across a number of key industries).
Tariffs have limited direct impact on growth
Source: Macrobond, Macquarie Macro Strategy, MWM Research, July 2018
China is not backing down from the Trump onslaught, ensuring that the stand-off is likely to intensify before it pacifies. Markets, which are already shaken, will remain under pressure until a negotiated outcome built on a degree of compromise between Washington and Beijing emerges. It is hard to put a timeline on this, suffice to say that the economic consequences might not be anywhere near as severe as the wounds inflicted on relationships between key allies and trading partners and/or markets which are also dealing with a number of additional headwinds such as rising interest rates, slowing global liquidity growth and waning economic momentum.
Macquarie believe it is difficult to model the likely impact of the tariffs (in large part because we have not seen protectionism of this magnitude in the era of global supply chains). However most market experts believe that the direct impact on global growth will be relatively modest, even if the threatened escalation is implemented. For example, at this stage, we estimates that the direct economic impacts of the current stated tariffs would amount to less than a 25 basis point (bps) hit to US and Chinese GDP (gross domestic product) growth combined (see Trade War 2018).
It is the secondary transmission channels that will amplify the negative impacts of an escalation in a tit for tat trade war. First, we are already experiencing a heightened level of financial market volatility and uncertainty; second, uncertainty has a dampening impact on business and consumer confidence. To date this has remained modest, but there is some evidence that signs of weakness are beginning to show up in soft data (i.e. Institute for Supply Management (ISM) and Centre for European Economic Research (ZEW) surveys) even if it has not reached the hard data; and Third, the potential for the impact of tariffs to work their way through global supply chains poses significant downside growth risk given nearly two-thirds of all trade is supply chain related. In addition, inflationary impacts could threaten output prices even if tariffs are only relevant to certain inputs.
How did we get here? Donald Trump did not start the trade war and it is highly improbably that he will finish it. As Macquarie’s regional equity strategist Viktor Shvets points out (see Trade Wars & Profits), most WTO members have been quietly gutting free trade for more than a decade. This explains why there are currently 50,000 cases of non-tariff protectionary measures in place, with the US accounting for only ~11%. Almost everyone is involved in almost all areas.
Non-tariff measures have doubled since the GFC
Source: WTO, Macquarie Research, MWM Research, July 2018
Similarly, the ratio of global trade to GDP peaked prior to the global financial crisis. The shift towards protectionism, nationalism and regionalism that has been reducing the free movement of trade in goods, people and capital, is structural and will continue to play out over many years in our view.
Global trade to GDP peaked a decade ago
Source: BEA, Macquarie Research, MWM Research, July 2018
GaveKal Research estimates that should the current rate of tariffs be implemented by the US, it would take them back to the 1980s in terms of the average tariff rate and back to the 1940s in terms of the proportion of goods subject to tariffs. This is a significant step backwards for globalization.
What is next? We believe there are strong political motivations behind the timing of Trumps trade war escalation. If he was to lose the house in the upcoming mid-term elections then he would likely spend the next 2 years of his presidency fighting off challenges by the Democrats. Stepping up the fight on trade “cheaters” shows a strong political voice without the risk of substantial near term negative impacts. We think he will continue to up the ante on trade protectionism with this potentially encompassing Europe and Japan.
Given the disparity between Chinese versus US imports (The US imports ~US$500bn of goods from China versus ~US$150bn in the opposite direction). This implies that China will have to look at alternative ways to deal with further US protection measures. We see this emerging in 3 key ways.
First, the Chinese can make it more difficult for US companies to do business in China; Second, the Chinese can make it increasingly difficult for foreign firms to gain access into the market; and Third, they could look to weaken the RMB or as a drastic measure to sell US Treasuries. We doubt after a prolonged effort to show currency stability that this would be a desired path, so more likely it simply becomes more difficult to do business in China. Perversely this might not matter much to President Trump who is pushing for the relocation of business and jobs back to the US over trying to sell more goods and services abroad!
What do we do? Despite its current safe haven status, the Australian dollar (A$) remains the liquid proxy for Asia and emerging markets (EMs) more broadly. Macquarie’s currency strategists expect the escalating trade war to push the A$ lower to $0.72 over the next three months. That is positive for the offshore earners provided there is no immediate impact on final demand. Our favoured internationally exposed stocks are: Aristocrat (ALL), Boral (BLD), CSL (CSL), Computershare (CPU), James Hardie (JHX) and Reliance (RWC).
However the combination of a stronger USD and a potentially slower China growth is negative for commodities. Base metals have dominated the headlines as a proxy for China growth (copper and nickel in particular) but agricultural commodities have also been punished (e.g. wheat and soybeans are down 10% in the last month) as investors question the long-term China growth story.
A secondary macro impact is the effect that China has on Australian wages and consumer spending through its impact on our terms of trade. Weaker than expected growth in China could prolong Australia’s wage adjustment and/or drive a domestic income shock which would have negative impacts on the consumer discretionary sector which is already under pressure.
For consumer related stocks operating in China (primarily A2 Milk (A2M) and Bellamy’s (BAL)) despite strong structural market share growth tailwinds, deteriorating growth momentum may drive short term corrections particularly given elevated multiples (as is the same for Treasury Wines (TWE)).
Incitec Pivot (IPL) will be negatively impacted here as these policies are negative for US farmers and hence fertiliser demand, while Nufarm (NUF) is a net beneficiary due to ~28% EBIT (earnings before income tax) exposure to Latin America (see Australian Ag/Chemicals – Potential tariff impacts). Inghams Group (ING) could also benefit from a decrease in wheat and soybeans prices (feed is1/3 of cost base).
Bluescope Steel (BSL) is one of the few direct beneficiaries from tariffs via elevated US steel spreads. Macquarie’s analyst has recently reflected this in the profit outlook (see BlueScope Steel – Keep calm and carry on).
Trade tensions and tariffs are positive for inflation and negative for growth. This is currently being played out in the US yield curve (2-10 year spread) which has flattened to 26bps, down from 52bps at the start of the year. This supports our increased allocation to more defensive exposures (cash and property) and rotation away from the banks (see Investment Matters – Sticking to our guns). We see trade concerns are an overhang on the market rather than the catalyst (isolation) for the start of a more severe correction.