President Xi Jinping has likened China’s challenge of overcoming hostility abroad to a “new Long March”, a reference to the Red Army’s epic 9,000 km, year-long retreat in 1934-35 from the then ruling Nationalists. It marked the rise of Mao Zedong and the birth of the communist nation.
His comments follow President Trump’s latest trade war escalation in which he raised tariffs on USD 200 billion of Chinese imports and threatened to slap a 25% tariff on another USD 300 billion, dashing hopes of a trade deal in May. The trade war is particularly troublesome for emerging markets equities, leading Robeco Investment Solutions to go underweight on the asset class in its multi-asset portfolio.
The IMF estimates that a full-blown trade war could shave 0.5% off US economic growth and 1.5% off China’s. With Chinese equities selling off by 13% in May, investors clearly have been discounting the odds of prolonged trade tensions, Van der Welle says.
“According to Xi, China is now on a ‘new Long March’ to overcome major challenges abroad,” he says. “The Long March analogy seems well chosen. It will still take decades for it to overtake the US in terms of GDP per capita, but China’s sheer size in terms of population and the aspirational goals set by the Communist Party have already put the country in the challenger position.”
“The pivot may also be read as a warning to Trump that trade wars are not ‘easy to win’, especially before the November 2020 US presidential elections, as China will be going for the long haul. Time may be on Xi’s side, but using this analogy also enables him to better explain an eventual near-term compromise on trade to Chinese citizens as a ‘tactical’ retreat in a broader setting of long-term geopolitical strife.”
“The largest incentive for the Chinese government to seek a compromise of any sort on trade is rising unemployment and the accompanying discontent among Chinese workers. With the Chinese PMI manufacturing employment index dropping in May to the lowest reading since March 2009 (47.0), past monetary and fiscal stimulus by Chinese authorities has clearly not been enough to mitigate the hit from US tariffs on an economy that was already cooling.”
“The first line of defense is more monetary and fiscal stimulus by Chinese policymakers, but a persistent drop in employment numbers could instill enough fear of social unrest for Chinese policymakers to eventually reach for a compromise on trade.”
Van der Welle says China has three retaliatory weapons at its disposal: restricting the rare-metal exports that the US relies on, selling its USD 1.2 trillion war chest of US Treasuries, and currency depreciation. The first two options are unlikely, he says, as they would be self-defeating, but “the most potent threat from the Chinese side remains a devaluation of the yuan.”
“A much cheaper yuan could mitigate the impact of additional US tariffs on the remaining USD 325 billion of Chinese exports to the US. However, the lesson learned from yuan devaluation in September 2015 is that it can backfire due to spiking volatility and tightening financial conditions in Chinese markets.”
“Ultimately, the short-term gain of a strong devaluation of the yuan would do long-term damage, as it would undermine China’s long-term intentions to gradually further open its capital markets to foreign investors. Is it a coincidence that at a time when the risk of a managed Chinese currency depreciation as a retaliation weapon grows larger, the US Treasury releases a report in which it toughens up its currency manipulation criteria? Probably not.”
“Cognizant of these self-defeating aspects of retaliation, Xi Jinping is now aiming for a “new Long March”. At face value this seems reassuring, as does his willingness to seek compromise around the upcoming G20 summit on 28 June in Osaka and his efforts to restore the recent dent in the great postwar liberalization of trade. It is not a given though; will Chinese defense systems make use of US software in the future (and vice versa)? The Chinese leader could very well be envisaging a new long march at home, not abroad. Protectionism will linger for longer.”
None of this bodes well for emerging market assets, Van der Welle says. “Unfortunately, the recent escalation in the China-US trade tensions and the opening of new fronts by the Trump Administration create additional downside risk, especially for more export-oriented countries that benefit from global trade,” he warns.
“In response to the negative news flow on trade, emerging market equity price momentum has worsened compared with developed market counterparts. This is understandable, as when protectionism rises, global trade volumes decline, and the earnings growth catch-up of emerging markets is hampered.”
“Enhancing corporate productivity growth by copying Western technological standards will become more difficult if trade barriers are pulled up. In a world of protectionism, emerging economies must enter the uphill battle of pushing the frontier of technological progress themselves.”
“Also, the recent decline in oil prices, reflective of lower global demand, is not helpful for emerging economies’ earnings recovery in the near term. As the valuation discount of emerging markets compared to developed markets is not particularly attractive compared to the average historical discount, we have become more cautious on emerging market exposure and lowered our emerging market equity positioning from neutral to a modest underweight.”
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