|26 August, 2019

An unresolved underlying strategic factor in the US-China trade war keeps financial markets on edge

Monte Safieddine is a market analyst at IG Dubai. He has spent nearly a decade in the FX industry and has held roles within financial firms that have included risk, analysis, statistics, and trading. Safieddine holds a Masters in Economics from Wayne State University where he completed multiple PhD-level fields and taught undergraduate students. He provides commentary on financial markets, including FX, cryptocurrencies and commodities, and publishes IG’s Daily Market Report and Weekly Market Report.

Website: https://www.ig.com/ae

'Strategic competitors' locked into worsening trade war that's dragging down global equities and forcing investors into safe haven products

Just when some investors were questioning the sanity behind negative yielding bonds, Friday’s shocker sent investors fleeing into bonds and forcing yields back towards fresh lows. China’s retaliatory tariffs on $75 billion worth of US goods was met with a US response of increasing tariffs by 5%.  That would raise tariffs on the initial $250 billion worth of Chinese imports into the US to 30%, and the remaining $300 billion worth of imports set to go into effect on September 1st and December 15th to 15%. 

I’ve mentioned previously (here) that as it stands, manufacturers in China that export to the US have been forced into three main options: (1) absorb those costs to avoid losing market share but dent future earnings, (2) pass them onto consumers which will seep into inflation rates down the line and suffer a drop in demand due to higher prices, or (3) pay up a one-time cost to shift elsewhere in the hopes that other manufacturing hubs have both the infrastructure and skilled labour to produce at similar costs to (at least partially) offset the tariffs, and hope no tariffs will be applied to the country where their new factory is set up for the foreseeable future.

The first option would be necessary for companies that produce in China but are competing in the US with non-Chinese manufacturers who aren’t exposed to the tariffs. The second option would require a price increase that wouldn’t be absorbed by US retailers given that their profit margins can’t cover the rise in tariffs even if consumer spending is rising, especially on say Apple’s products that are far less than the average profit margins in the retail sector.  No surprise then, that Apple decided to absorb most of the additional tariff costs when the 10% tariff on the remaining $300 billion worth of Chinese imports were first announced in order to keep prices unchanged, and lagged the most in the Dow index on Friday when news of additional tariffs hit the wires.  

The PBOC allowing the yuan to drop in value past the infamous seven mark against the US dollar earlier this month was in hopes of helping companies in China offset the increase in tariffs, and entice them into staying by making the first two options less painful, hoping they’d avoid the third altogether. A weaker currency would make exports cheaper, so after applying the US tariffs the net price in dollars would keep the product’s price relatively competitive.

That strategy however, looks far less likely at this stage, with US President Trump’s comments ordering American companies “to immediately start looking for alternatives to China” and further retaliatory moves from both sides effectively raising the risk of a clear fundamental decoupling of both economies, and in the process shift supply chains and raise manufacturing costs at a time when many global manufacturing PMI figures are already posting contracting figures.  Shifting outside of China will be costly, especially if those countries have worse terms, infrastructure nowhere near as strong, and skilled labor not readily available.

In the meantime, one can’t help but notice that a currency war may be brewing in the background as the greenback lagged significantly on Friday against most of the remaining FX majors, and the Chinese yuan weakened against an already battered greenback for its eighth consecutive session to reach highs unseen in over a decade.

And then there’s the Federal Reserve, whereby Fed Chair Powell’s speech on Friday avoided mentioning any further easing but highlighted a “deteriorating” global outlook and a central bank looking to “sustain the expansion”.  The rhetoric wasn’t to Trump’s liking, questioning whether he or Chinese President Xi was the “bigger enemy”. The lack of mention of future monetary policy action combined with the rise in trade risks that for the Fed is unchartered territory is keeping rate cut likelihoods fully pricing in one come September, and another before the end of the year.

However, keep in mind that even with demand subdued, rising tariffs/costs will eventually force manufacturers into raising prices that’ll push CPI figures higher, and witness a potential revival of stagflationary forces where the economy suffers higher prices, higher unemployment, and stagnant demand. This would be especially true if currency devaluations are the next tactic in the trade war, and likely hurt net importers like the US, UK, and India with higher inflation rates than net exporters like China and the European Union. And heightened inflation similar to say the 80s would force the Fed into shift its priorities from the current case of extending the business cycle to reigning in higher prices.  

Lastly, it’s important to note that the underlying factor behind what is happening isn’t a reduction in the US trade deficit, as although Trump’s preference is for companies to manufacture in the US, the key item is for companies to manufacture anywhere but China. Any trade deal that is made between the US and China – however unlikely – is easily at risk of eventually being undone, and any future breakthrough in talks an exception to what is now a norm of a breakdown in negotiations.  Stunting China’s growth and preventing it from overtaking the US remains the number one concern, as ‘America First’ attempts to keep China second, if not further down the pecking order.

* Any opinions expressed in this article are the author’s own

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© Opinion 2019

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