How quickly things change in a few weeks. Just over a month ago the world was expecting an imminent trade deal between the U.S. and China, hundreds of pages of text had been negotiated and communication from senior leaders had been overwhelmingly positive. Now as tariffs are on the rise and the U.S. is targeting Chinese tech firms with restrictive measures, talks have collapsed and U.S.-China relations appear to have taken a fundamental shift. As the world looks forward to the upcoming G20 for signs of whether or not the U.S. and China can resolve the current trade impasse, the recent restrictions on Huawei are a reminder that the trajectory of the U.S.-China relationship has changed and a durable long-term resolution is unlikely. While we think a trade deal is still possible, recent escalation will make a deal harder to achieve and there are risks that the fundamental goals of both sides have changed. Furthermore, even if both sides can conclude a trade deal to reduce tariffs, the mistrust and conflict in the tech sector will continue, and any deal is only likely to be a temporary truce.
Superpower trade war, global impacts
With tariffs now in place for approximately one year, the negative impacts on trade, investment, and supply chains are clear. Trade between the U.S. and China has dropped significantly, as expected – Chinese exports to the U.S. were down 12% year-to-date (YTD) from last year1, and U.S. exports to China were down 20% YTD2 (see Exhibit 1). The impacts are also being felt more broadly, global export growth dropped to its weakest point since the global financial crisis over the first two months of this year (see Exhibit 2). In addition to trade, business sentiment has weakened and uncertainty over tariffs and supply chains is causing businesses to delay or cancel investment. For example, manufacturing fixed investment in China is down sharply at -1% year-on-year(y/y)3 (see Exhibit 3) and global PMIs dropped from 54.7 in early 2018 to 51.1 in May4. It’s not all bad however, trade redirection is creating some relative winners. For example Vietnam’s exports to the U.S. increased 40% y/y in Q15, and India increased 15% y/y.
Exhibit 1: China import growth by region
Exhibit 2: Tariffs have negatively impacted global trade
Exhibit 3: China manufacturing investment down sharply
A breakthrough at the G-20?
As the effects of the trade war continue to be felt across the global economy, the focus is now turning towards the upcoming G-20 Leaders’ summit for signs that the two sides might be able to find an off-ramp. We think the G20 represents a good opportunity to de-escalate and resume talks, perhaps the last good opportunity, but think a simple agreement to resume talks is the best possible outcome. As such, due to the complexity of outstanding issues and length of negotiations, any eventual deal would likely not be until late 2019 or early 2020. This means tariffs could remain in place for several more months, continuing to weaken sentiment and inflict costs on the global economy. In past trade wars, it’s usually the negative economic and market consequences that bring about a willingness to negotiate. We believe both sides still want a deal, and understand that a deal is ultimately in their best interests. However, as negotiating positions shift and intentions become less clear, the outlook for a trade resolution has become cloudier.
While many market participants hopeful that the G20 can bring about yet another détente, the risks of further escalation can’t be ruled out. In the event future negotiations fail to achieve a trade deal, how could further escalation impact the U.S. and Chinese economies? The economies are impacted differently: through weaker exports and investment, the Chinese economy would feel the effects in the labor market and domestic demand. The U.S., due to its smaller export share, would primarily see the negative impacts through higher consumer inflation and weaker financial conditions due to pressure on corporate margins and weaker revenues for large U.S. companies with China exposure. In this event China could see a deeper reduction in growth, but the U.S. could see a larger increase in inflation.
The longer terms impacts are harder to measure. The U.S. and China are two of the most deeply intertwined economies on the planet. They are each other’s largest trading partners and have extensive bilateral investment and capital flows. A decoupling scenario that pulls apart supply chains and increases barriers to the flow of goods, capital, and people would impose substantial costs on global corporates and substantially reduce growth. Nevertheless, the trend may already be happening. And certainly has been happening in the internet space for nearly ten years. The message from the Huawei sanctions is clear––Chinese firms may increasingly reduce their exposure to U.S. suppliers, and U.S. firms may reduce their exposure to Chinese customers. Regardless of the outcome, this trend may continue.
Seeing different realities
A trade deal is still possible, but a gap that is emerging is how the U.S. and China view the trade war, which could make a deal harder to achieve and enforce. The U.S. has continued to justify the use of tariffs as a response to China’s years of perceived unfair economic practices. U.S. grievances range from China’s tariff levels, closed service sectors, and widespread intellectual property (IP) theft. The justification for tariffs and stated goals of negotiations are primarily economic. In China, these justifications often come across as baseless. China’s recently published white paper squarely placed blame on the U.S. for starting the trade war. Furthermore, the already popular belief that the trade war isn’t really about trade, but instead about containing China’s rise, is now bordering on a consensus view inside China. This view is increasingly justified by the shift in recent weeks where the U.S. went from efforts to negotiate a deal aimed unequivocally at opening China and deepening U.S.-China economic ties, to putting restrictions on Huawei that appear as efforts to contain China. This contradiction has raised many questions and could make China less likely to strike a deal when they see this conflict as part of a longer, and inevitable struggle. For these reasons, we stress that any eventual deal is likely not an end to U.S.-China tensions, which appear likely to continue along many dimensions.
How to invest amidst a trade war?
Navigating these trends is proving increasingly difficult for investors. Not only is it problematic to estimate the near-term growth and earnings impact of a trade war between the world’s two largest economies, but also estimating the potential long-term ramifications could be even more difficult. With supply chains increasingly being exploited for strategic gain by countries that sit on key hubs, the system of integrated supply chains that brought about significant economic efficiencies over the last two decades risks breaking down. In this environment we are broadly favoring more defensive sectors with less trade exposure such as healthcare and communication services as well as yield generating assets. Among global markets, U.S. equities may be more resilient as there is less direct exposure to trade tensions given a more service oriented economy. The S&P 500, which includes a high allocation to big index weights such as Facebook, Google, Amazon, and Microsoft, actually has little direct exposure to China. In this regard, according to data from the U.S. Bureau of Economic Analysis, China accounts for only approximately 6% of U.S. multinational overseas sales revenue (see Exhibit 4). The global economy is increasingly under stress, however understanding the nuances of trade and geopolitical shifts can still yield investment opportunities.
Exhibit 4: Europe and Asia ex-China are majority of total foreign sales
1 Source: U.S. Census Bureau, China National Bureau of Statistics. Data as of April 30, 2019.
2 Source: U.S. Census Bureau, China National Bureau of Statistics. Data as of April 30, 2019.
3 Source: IHS Markit, J.P. Morgan Private Bank, Haver. Data as of April 30, 2019.
4 Source: IHS Markit, Netherlands Bureau for Economic Policy, Haver. Data as of March 31, 2019.
5 Source: Vietnam Ministry of Statistics, US Census Bureau as of March 31, 2019.