I have just returned from an annual conference in Washington devoted to the topic of China and the US. While the event primarily focused on the coordination between the two countries from the perspective of financial markets and their regulation, the conversation spilled over to the geopolitical issues as well. Needless to say, this year the trade disputes were front and center of the discussions.
When I attended the same conference a year back, the US had gone through its ‘first wave’ of tariff threats against China and held a hard line. Even those who did not sympathize with Trump’s modus operandi, seemed sympathetic to the reasons behind the tariff threats. At the time, the Chinese side was less belligerent, far more conciliatory, and more interested in understanding what the US were really aiming at.
Fast forward 12 months, the tables were turned. Many of the Chinese participants were holding a harder line than the US side, as their widespread opinion was that the aim of the US was actually to humiliate China rather than negotiate an agreement for economic reasons. Last year, some of the Chinese participants hinted to the fact that President Xi might have brought the ire of the US and the rest of the developed world upon China by being too aggressive in the Made in China 2025 plan. This year, they fully supported the stance of the Chinese president.
Among the US participants, this time around there was a lot of debate on the potential impact of tariffs on domestic inflation, company earnings and, more in general, the overall US economy. The opinions were split, with some thinking that the US would continue to show good growth numbers and low inflation, while others were starting to worry about the medium-term implications on the economy. There was also an increased frustration with the Trump administration and its lack of a real long-term strategy in its (kind of) economic policy.
During the event, I also had a lot of discussions on Huawei and the IP disputes. The issue of IP theft and disregard for sanctions is real and thriving among Chinese corporates (one patent lawyer told us about the practice of inundating the US patent office with hundreds of bogus applications to divert its attention). Therefore, even if there were a short-term reprieve packaged into a trade deal (and this is a meaningful ‘’if’’), the IP battle is destined to continue. President Trump’s statement at the G20 that US companies could continue to sell products to Huawei is a first positive sign but could easily be retracted or not followed upon by a more comprehensive agreement.
Looking at the investment implications of my meetings, I continue to believe that a trade deal is important for equity markets. This is not just simplistically from a sentiment viewpoint, but more concretely because of the impact of tariffs on company earnings both directly (such as the hit on margins if the tariffs cannot be fully transferred to customers) and indirectly (such as the potential impact on demand as well as the higher costs derived by the supply chain reorganization). Let’s not forget that earnings remain a key driver of stocks, especially in emerging markets. For a deal to be effective, we need it to lead to the removal of tariffs, at the very least the 25% on USD 200 bln recently imposed and the 25% threatened on USD 300 bln that were eventually put on hold during the G20. Anything else (such as a Huawei reprieve) would be a bonus.
Therefore, I see the outcome of the trade disputes as a relevant issue. I continue to believe that we should expect a trade deal sometime in 2019. While the Chinese government is putting up a tough front, Trump’s concern around losing constituencies and his obsession with US equity markets could soften his stance to the point of making it more acceptable for China to go back to the negotiating table.
That said, the event did change my opinion on the timing of a deal (later than I initially thought) and the potential volatility of the market in the meanwhile (which could hence drag longer than I initially thought). While the decision to resume talks at the G20 is positive, it is still nowhere close to a deal. I believe that the Chinese government is now determined not to give in easily to what it believes is the US administration’s attempt to humiliate it, and is prepared to sacrifice economic growth to do so. I also think that, unless we have a deal before December, we are probably not going to see one until after the Presidential elections. This would imply tariffs for longer, with all the likely negative impact on companies’ earnings and disruption in global economic activity. From early 2020 we will get into Presidential campaign mode, with the first caucuses, and it is unlikely that Trump would want to keep the subject in the headlines.
From an investments viewpoint, this implies the likelihood of equity markets volatility (particularly in EM) over the summer. I also continue to be very worried about supply chains, particularly in IT. Companies will not only have to incur investments and costs to transfer their supply chains outside of China, but this will imply the likely fragmentation of such chains (there is hardly any other country such as China that can currently offer the same level of availability of workers and infrastructure) and an increase of production costs that will outlast the trade and IP disputes. The potential creation of two IT ecosystems, one led by China and one by the US, would also have far-reaching implications on IT development and costs.