By Hamlin Lovell, NordicInvestor
Could Asian Credit prove to be resilient?
Headlines such as “a new Cold War between the US and China” may be journalistic hyperbole. Trump pursues his personal brand of “truthful hyperbole”, which has not met the Washington Post’s fact checking criteria 5,000 times (and counting). Single sentence soundbites attributed to Chinese officials also cannot do justice to the intricacies and complexities of the political and economic cross currents underlying trade disputes. Muzinich portfolio manager, Christina Bastin, offers a cold, hard and dispassionate perspective on the trade war, and its implications for investors.
“The trade war is here to stay and we should be braced for multi-decade contention as recent rows about the China South Sea show. China wants to pound its chest and show that the Middle Kingdom is big, relevant, and standing up to the US” she says.
The media arena portrays the trade war as bilateral brinkmanship between Trump and China, but it actually has wider geopolitical bases. Plenty of other countries may be less vocal – and generally want to avoid the adversarial politics that Trump thrives on – but are equally irritated by China’s perceived economic malpractices (and its sabre-rattling: the UK recently entered the South China Sea fray with Royal Navy First Sea Lord, Admiral Sir Philip Jones, committing to send more ships through disputed areas).
“When China signed up to the WTO in 2001, it committed to a more market-based economy but China dictates its own rules that favour its own companies. China has free access to Western markets, but has not reciprocated. Companies wishing to do business in China must find a local joint venture partner – and sacrifice their intellectual property and patents.
Foreign banks cannot buy Chinese banks. The US and the EU would both like to see China allow foreign companies to enter the market without joint ventures, without relinquishing IP, and a more open financial system” points out Bastin.
Yet such concessions could be at variance with President Xi Jinping’s key goals. “China is using Communist-style central planning to implement its strategic aspiration to improve the value added of its exports, and perceives the US as an existential threat to this model” she explains.
Trade wars can include “beggar thy neighbour” competitive currency devaluation or depreciation. China stands accused of currency manipulation, but Bastin argues that, “Although the RMB has weakened against the USD, so too have other Asian currencies. Therefore, the RMB has actually appreciated against a broad basket of currencies including China’s neighbours and trading partners”. Contrary to Trump’s rhetoric and campaign promise, the US Treasury in its latest report in October stopped short of classifying China as a “currency manipulator”. Bastin “does not expect China to aggressively weaken its currency, as given the porosity of the capital account, a weaker currency spurs capital outflows, which are at odds with Chinese policy to keep money in the country. China does not want a repeat of 2015 when it could not stabilise FX and capital outflows accelerated”.
China has historically sat out trade war for years, and is now in an even stronger position to do so. China’s economy is increasingly domestically driven with vast pools of savings.
“Local washing machine makers have recorded tremendous growth, despite US tariffs imposed after 2008. Just 11% of China’s exports go to the US, so tariffs on 40% of them are only about 4.4% of Chinas’ overall exports. These could easily be replaced by exporting elsewhere.” says Bastin. Estimates do vary. Bloomberg recently reported that Fang Xinghai, vice chairman of the China Securities Regulatory Commission, had estimated a 0.7% GDP decline from tariffs being put on all exports to the US. Still, this is not a huge blow to an economy growing at nearly 7% per year.
“The second order impacts on sentiment, risk appetite, levels of investment, and supply chains elsewhere in Asia, are much harder to forecast”, she acknowledges.
A Pyrrhic victory
Meanwhile, an escalation of US tariffs is likely to prove ultimately self-defeating, for multiple reasons.
The first $50 billion round of tariffs were almost all on industrial goods.
The second round of tariffs, on $200 billion of Chinese exports, contain a larger share of consumer goods and are roughly evenly split between pure China goods and those assembled in China using imports.
“If the trade war revs up to a third round covering all $500 billion of China’s export to the US, three quarters of goods affected would be consumer goods, such as laptops, phones and sports shoes, which must have a noticeable impact on US inflation” says Bastin. “US Trade Secretary, Wilbur Ross’s claim that consumers will not notice price rises spread over thousands of products is laughable.”
Incidentally, Brazil operates highly protectionist policies that result in an iPhone – comprised of locally source components – costing twice as much as it does in the US. A political backlash against tariffs would occur long before the US comes close to such a scenario.
And the blowback might not only come from US quarters. Any “round three” would also have much wider repercussions: “75% of goods impacted would be non-Chinese, feeding into global supply chains, and slowing global growth” says Bastin.
Additionally, “Chinese tourist numbers headed for the US during the recent holiday, have crashed 30%- without any moral suasion from the authorities. This is not good for US export earnings” she points out.
Meanwhile, China’s retaliatory measures have targeted Trump’s power base with laser accuracy, applying to agricultural exports such as soybeans from “Red state” Republican strongholds in the Midwest, such as North Dakota, where farms have already gone bankrupt. This has led to $12 billion, of subsidies, which once vocal fiscal conservatives in the Republican party are relaxed about, as the US budget deficit comes close to record levels. Realistically, the US cannot afford to bail out everyone who might be hurt by China’s retaliatory measures, so there must be some limits to subsidies – whether or not the fiscal conservatives re-assert authority.
Overall however, Bastin believes China is in a good position to mitigate the trade war impact. “It has an enormous policy toolkit that is the envy of other nations” she added. It has already shown how fast it can act in its economic policy responses to the US, having made a number of RRR cuts this year to inject liquidity into the system. At the fiscal level it has already implemented local government stimulus, tax reform as well as import tax reform, while pro-growth policies (regulation) are also being carried out, although these are more longer-term in nature.
Essentially, the country is managed by one central, single party system, which makes it much easier to implement new policies quickly and effectively. In addition, because it is not exposed to a short election cycle, China can focus fully on its longer-term outlook.
Implications for investors
Shanghai equities have touched four year lows, and most other Asian equity markets have seen losses to varying degrees. Bastin thinks: “it is logical for equities to sell off in response to the trade war, and Xi asserting his power and slower growth”. China’s headline GDP growth has slowed to a rate of 6.5% in the third quarter, the lowest since the GFC.
Bastin does not think that the selloff in Chinese high yield corporate debt is justified however. Credit ranks above equity in the capital structure. “Credit investors do not care so much about slowing growth, so long as companies stay solvent and can repay them”.