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Manish Singh, CFA | Chief Investment Officer

Crossbridge Capital

Are we in for a US-China trade war?Summary

From haggling over the price of tea on a quayside in Guangzhou in 1784 to trading in electronics and t-shirts today, over the course of more than two centuries, trade between the US and China has grown beyond imagination. This trade relationship is now the most significant in the global economy.

The world’s two largest economies account for 40% of global GDP, a quarter of all exported goods, and 30% of the world’s Foreign Direct Investment (FDI) outflows and inflows. Their fates are inextricably linked. In a way, they complement and need each other. The US cannot compete with China when it comes to manufacturing and China cannot compete with the US when it comes to product design or research and development capabilities.

The world’s most cost-competitive and largest electronics industry supply chain is in Shenzhen, China. China’s manufacturing capacity is so well honed and organised that it accounts for more than 25% of global manufacturing. It is my firm belief therefore that there will be no US-China trade war on the scale that may worry us all – and tariffs are just a negotiating tactic, albeit a necessary one. I see China opening itself up more to US exports. The US-China trade deficit will start to close meaningfully when the prosperity of China’s middle-class increases and they demand services that the US can export to China. Therefore, it is not just in the US and China’s, but also in world’s interest, that a China –US trade war is averted

Trading with China: From tea to t-shirts

It was a frigid morning on February 22, 1784, also the 52nd birthday of George Washington, who five years later would become the first President of the United States. Two ships – Empress of China under the American flag and Edward under the British flag, set sail from New York harbour on two different but historic voyages. The United States had been an independent nation for only five months. The Treaty of Paris signed the previous September had concluded the war with Britain and freed American businesses from trading restrictions placed on them. America was free to trade with anyone it pleased and the first focus was on China, in order to satisfy the country’s urge for tea and other commodities.

This ambitious young nation, desperate to forge trading links with the Middle Kingdom, had no time to waste. US merchant ship Empress of China set off down the East River, past a 13-gun salute (one for each of the states that were then united) on a fifteen-month voyage to China. Destination: Canton (modern Guangzhou) and carrying a full load of cargo – ginseng, lead, silver coins and woolen cloth. The merchants aboard the ship dreamt of riches to be made by bringing back tea from China. On the very day that the Empress set sail, the Edward, a ship bound for London, departed from the harbour to deliver the congressional ratification of the Articles of Peace between the United States and Great Britain. The Empress set in motion the US-China trade relationship that is now the most significant in the global economy. The world’s two largest economies account for 40% of global GDP, a quarter of all exported goods, and 30% of the world’s Foreign Direct Investment (FDI) outflows and inflows. Their fates are inextricably linked.

American Historian Eric Jay Dolin in his book When America First Met China writes that trade with China quickly became a US national priority and, between 1784 and 1833, there were to be at least 1,352 officially acknowledged visits by American ships to China. Ships plying the seas between the United States and China helped build vast fortunes for US merchants in New York and New England. Many became millionaires overnight and ploughed their riches into shipbuilding to build an ever-faster ship to conduct more trade with China. The money also went into building America’s infrastructure – including banks, canals and railroads and set up wealthy American dynasties such as Astor, Forbes and others. Fashionable Americans coveted all things Chinese. President George Washington and his wife Martha filled their home with the finest chinaware. Tea had been an American obsession since the mid-seventeenth century and although the Boston Tea Party in 1773 led to many Americans giving up tea as an unpatriotic beverage and turn to coffee, the majority still craved for tea.

However, trading with China came at a cost – a trade deficit. America didn’t have much that China coveted. Then, as now, America imported more from China than it exported. From haggling over the price of tea on a quayside in Guangzhou to trading in electronics and t-shirts today, over the course of more than two centuries, US-China trade has grown way beyond any 18th Century imagination. Today, US-China trade in goods is worth $578 billion (with the trade balance in favour of China by $347bn).

So can the US-China trade deficit be bridged? If not, are we in for a US-China trade war?

To date, only three of forty-seven major US trade associations have publicly come out in favor of US President Donald Trump’s new tariff programs, with the balance opposed. In 1987, to rein in the US trade deficit with Japan, US President Ronald Reagan hit $300 million worth of Japanese imports with 100% tariffs for Japan’s failure to open its market to US semiconductors. The US could do that to Japan because Japan was, and is, a US protectorate, China is not. The British solution to its balance-of-trade crisis with China in the 19th Century, was large-scale illegal opium trading and, when that didn’t work, Britain embarked on one of the biggest thefts of intellectual property to date – stealing Chinese tea plants, as well as Chinese tea-processing expertise, in order to create a tea industry in India. Not sure that’s an option today…

The US and China, in a way, complement and need each other. The US cannot compete with China when it comes to manufacturing and China cannot compete with the US when it comes to product design or research and development capabilities. Apple’s iPhone is a product of US engineering talent and Chinese manufacturing prowess, with each phone carrying the line “Designed by Apple in California. Assembled in China.” The world’s most cost-competitive and largest electronics industry supply chain has taken shape in Shenzhen, China. There are more than 700 suppliers of Apple’s iPhone and computer products in the world, nearly half of which are in China. China is playing an increasingly important role in the global supply chain. China’s manufacturing capacity is so well honed and organised that it accounts for more than 25% of global manufacturing. China is the leading producer of 220 of the world’s 500 major industrial products and is the only country that has all the industrial categories in the United Nations Industrial Classification.

According to the US-China Business Council (USCBC), in 2015, US exports to China and China-US two-way investment contributed US$216 billion to US GDP and supported 2.6 million US jobs.  That’s a lot of jobs for the US to risk. For the US, China is the largest export market outside of North America and an important overseas market for many US products – agriculture, automobiles and integrated circuits. 25% of the aircraft delivered by Boeing are to China. In 2016, Chinese tourists and students in the US spent more than US$51 billion.

It is my firm belief that there will be no US-China trade war on the scale that may worry us all and tariffs are just a negotiating tactic, albeit a necessary one. I see China opening itself up more to US exports.

While the US promulgated the Patent Act and Copyright Act in 1790, the Antitrust Law in 1890; and established the Securities and Exchange Commission in 1934 and the Committee on Foreign Investment in 1975, it was not until 1992 that China established a socialist market economy system. Since then, it has made remarkable progress. Multinationals emerged in the US as early as in the 1860s, where as Chinese multinationals are only a couple of decades old at most. China is determined to engage and play a crucial role in formulating international rules and laws going forward. China’s ambitious trade projects like the One Belt One Road (OBOR) and leadership in the Paris climate Accord are clear signs of intent.

The way I see it, the US-China trade deficit will start to close meaningfully when the prosperity of China’s middle-class increases and they demand services that the US can export to China.  China’s GDP/Capita, at $8,200, is one-seventh that of the US. Imagine the upside to world trade if that GDP/Capita ratio were to just double, let alone go any higher. Therefore, it is not just in the US and China’s, but also in world’s interest, that a China –US trade war is averted.

Markets & the Economy

The key concern for the market is clearly around the US trade tariffs on China. Although China’s Commerce Ministry reacted angrily to Trump’s tariff announcement, Chinese officials have been careful not to escalate the fight. In rolling out tariffs on $3 billion of US goods, China carefully left out the biggest US exports to China – soybeans, sorghum and Boeing aircraft. This, as I have pointed out in the section above, underscores China’s willingness to negotiate a solution with the Trump administration. Any progress in China-US trade talks and indeed China-EU trade talks will be positive for the market. China and other current account surplus nations – Germany, Japan, Korea amongst others, have been looking for specific demands from the US and, so far, have been frustrated over a lack of clarity from the Trump administration. With the US now making specific demands, there is hope that it could lead to a negotiated deal.

Last Wednesday, the US Federal Reserve (Fed) voted unanimously to raise its benchmark Federal-Funds Rate by a +0.25% to a range between +1.5% and +1.75%. Fed Chairman Jerome Powell, in his first news conference as chief, drew high praise for his often succinct and non-academic remarks.  He commented that there is still “no sense in the data that we are at the cusp of an acceleration in inflation,” emphasizing that tightening can continue to be gradual. A well-signaled rate rise, which is fully anticipated, like the one we saw last week, eases the anxiety in the markets and gives it more runway and stability.

The Fed delivered a message of strong growth, moderately rising inflation, a healthy jobs market and slightly steeper rates i.e. an outlook that supports higher equity prices. The Fed now expects US GDP growth for 2018 to be at +2.7%, up from the +2.5% predicted in their last forecast as well as an increase in the 2019 growth forecast to +2.4% from their last estimate of +2.1%.

There’s also cheer on the UK economy front. The UK is now running a current budget surplus (the surplus that excludes capital investment) for the first full year since 2001. The UK also saw the fastest increase in productivity in six years, the fastest increase in real wages in three years, as well as falling inflation and record low unemployment. I fully expect the Bank of England (BoE) to raise rates at its May meeting and GBP/USD to trade strong and stay well clear of the 1.40 level, heading to 1.45 by mid-May. The UK and the European Union (EU) have also agreed on a transition deal that keeps UK in the EU until December 31, 2020, easing business fears over a post-Brexit cliff edge. While the UK had to make concessions on the rights of EU citizens arriving to the UK during the transition period, crucially the agreement also confirmed that the UK would be able to sign (but not implement) trade deals with non-EU countries during the transition period. The UK will now be able to negotiate and prepare trade deals worldwide, ready for signing the day after it leaves the EU.

Meanwhile, in Asia, Japan’s economy grew at an annualized rate of +1.6% in Q4 2017, thanks to robust corporate spending in a fresh sign of strengthening domestic demand. Japan has posted its longest growth run (8 straight quarters) in 28 years.

With Mike Pompeo as US Secretary of State and John Bolton as US National Security Adviser, it seems the die is cast for the US to pull the plug on the Iran nuclear deal. Trump explicitly mentioned differences with outgoing Secretary of State Rex Tillerson over Iran in his decision to remove him. I suspect the decision is made already and it will be announced mid-May when Trump has to give his semi-annual approval for the deal, for it to continue for another six months.  The collapse of the Iran nuclear deal would be bullish for oil despite the increased oil supply from the US. A tactical long in oil majors (Total, Chevron) and oil services (Schlumberger, Halliburton) could be a good trade to set up.

The Eurozone economy enjoyed its strongest year of growth for a decade last year, growing by around +2.5%, and while the growth expectation for this year was lowered to +2.3%, this is still better than the +1% the Eurozone struggled with for a long time following the financial crisis. European Central Bank (ECB) President Mario Draghi is coming under increasing pressure from a growing faction of ECB officials to start raising interest rates in the middle of 2019. Bundesbank President Jens Weidmann, who is widely tipped to succeed Draghi at the ECB later next year, has been quietly rallying support for the ECB to wind down its Quantitative Easing (QE) program and prepare for a rate rise. Bear in mind, Draghi doesn’t have to yield and he has data on his side.  Eurozone inflation, at +1.1% in February, is still far too weak and a strengthening Euro currency as well as possible trade war are all risks.

So in summary, I remain underweight the Eurozone and overweight US equities because of the relative strength of the US economy. My sector biases – Financials (XLF), Industrials (XLI), Technology (XLK) with a tactical long in energy (XLE)

In terms of stocks I like: JP Morgan (JPM US), Bank of America (BAC US), Citi (C US), VISA (V US), Blackrock (BLK), Allergen (AGN UN), Celgene (CELG UW), Gilead Sciences (GILD US), Apple (AAPL UN), Google (GOOG US), Microsoft (MSFT US), Amazon(AMZN UW), Alibaba (BABA US), Baidu (BIDU US), JD.com (JD US), Salesforce (CRMUS), Home Depot (HD UN), Estee Lauder (EL US), Glencore (GLEN UN), Rio Tinto (RIO LN), Freeport McMoran (FCX US), Schlumberger (SLB US), Halliburton (HAL US) WallGreenBoots (WBAUS), CVS Health Corp (CVS US), YUM Brands Inc. (YUM US), BNP Paribas (BNP FP), Barclays (BARC LN), Vinci (DG FP), Eiffage (FGR FP), Pepsi (PEP US), Kraft-Heinz (KFA US)

Best wishes,

Manish