The battle lines are hardening
As the title implies, this is an extension of last month’s article “The China Siege.” There have been several developments in the conflict, but the most salient point is this: both sides have hardened their positions and have repeatedly signaled that they will not submit to their opponent. China’s ministry of finance has vowed to “fight to the end.” On the other hand, President Trump asserts that our trading partners “want to make a deal” to avoid the pain from an ongoing conflict. Time will tell which who is right.
Siege warfare is a test of patience, and both sides have indicated their willingness to endure short term pain to achieve their long term goals. While the conflict lingers, what actions can each country take to put additional pressure on their opponent? How might the main players parry the likely incoming attacks? Here, we discuss how both sides have positioned themselves over the past few weeks.
Last month’s article described the initial volleys the US and China could strike upon one another in a trade war, starting with tit-for-tat tariffs. However, China exports more to the United States than the US exports to China, so matching perfectly the scale of tariffs, dollar for dollar, isn’t possible. Since China has a greater vulnerability to a traditional trade conflict, they may utilize asymmetric tactics to mitigate the imbalance. A decade ago, economists worried about this theorized avenue of attack: China could unload a sizable chunk of its US debt on the debt markets, which could lower our bond prices, thus increasing the amount of interest payments necessary for new debt issuance. Given the reasonably large appetite for US bonds (given weak yields elsewhere in the world), and the fact that it would lower the balance sheet for China’s remaining bond holdings, this line of attack seems less probable. So, how else could China strike the US?
China could restrict magnetic and rare-earth mineral exports (e.g. monazite or bastnasite); these essential metals are vital for many industrial, military, and consumer products. Since 70% of rare earth minerals come from China, the US is working hard to secure other supplies to deny China leverage during negotiations. This line of attack is quite possible.
The US has also opened up new attacking tactics over the past few weeks. Readers of our blog will know that the administration has begun using individual companies as bargaining chips in their grand strategy. For example, the Chinese telecomm monolith, Huawei, was recently put on a US blacklist, preventing US suppliers (e.g. semiconductor firms and operating system software providers) from selling to them. In response, China is creating an “unreliable entity list” of its own to blacklist US companies. Individual US companies trying to make headway may get wrapped up in retaliatory action. Furthermore, the companies already doing business in China, like GM, are bearing additional burdens from the already implemented tariffs. Finally, China’s overarching industrial strategy of increased self-reliance and technological superiority – the “Made in China 2025” effort – may be accelerated as a result of seeing the US as an unreliable partner.
So far, investors are taking it well
There are already signs that the existing conflict is having a modest, but real, negative effect on the economy. Despite slowing economic growth (exemplified by weak wage growth and job creation numbers), the recent weeks have been surprisingly good for the stock market. A substantial reason investor confidence remains high is Federal Reserve Chairman Jerome Powell’s indication that the Fed will use accommodative monetary policy to counteract recessionary tendencies brought on by trade conflicts.
Investors love easy money. However, some analysts worry that dropping rates might create a new set of economic problems. First, lowering rates might actually be a recessionary signal. Until now, investors have been immune to bad news, but we don’t know if that would continue through a clear declaration of “no-confidence” in the form of a realized rate-cut. Second, borrowers which expect an era of continued rate-declines (i.e. a slowdown or recession) could actually wait for rates to hit rock bottom before signing paperwork for new homes mortgages, business loans, and so on. So, starting a cycle of rate-cuts may perversely slow lending as potential borrowers wait for the lowest possible rate. Third, monetary intervention creates a long term moral hazard problem because “bad” behavior is being encouraged (or at least tolerated) because of external protections. Finally, the financial sector may suffer if rates drop quickly. Banks and other lenders prefer higher rates since they are currently paying deposit-level rates to current clients. Rate cuts in general hurt lenders since there is little margin to create value. Moreover, if the Fed cuts rates rapidly, their potential for income drops while they are still obligated to pay higher deposit level rates, creating a net negative cash flow.
Impact to other countries
China and the United States are two major players in conflict. Since they are the two largest economies in the world, it was inevitable that other countries will experience some secondary effects. If the trade war escalates to a point where global growth is negative, every other country’s growth trajectory will be weighed down. However, to date, we have only experienced very limited skirmishes. In fact, the secondary effects for other countries have generally been positive, since rerouted trade is now flowing through more diverse ports of call.
To review last month’s article (within the section “An Incomplete Siege”), we discussed how global supply chains and rerouted trade could actually undo the intended consequence of an isolated wall between China and the US. Like water hitting a rock, the stream of trade flows around the barrier, but continues nonetheless. In our article, we suggested Malaysia and Brazil – as a regional trading hubs – could be the major beneficiaries of rerouted supply chains. That guess was partially correct. While these countries (along with Taiwan and Chile) have taken on additional flows, CNBC reports that Vietnam has actually been the greatest winner in the conflict. Massive additional trade flows - accounting for 7.9% of their GDP - is now pouring through Vietnam as a result of the enmity between China and the US.
Finally, there is one more wildcard in regards to the trade dispute with China: Mexico. On May 30th, President Trump has suggested that he will create a blanket tariff of 5% on all Mexican imports until our neighbor takes action to prevent migrants from crossing our southern border. He sent a deadline of June 10th for Mexico to respond. Politically, these threats have put the NAFTA revamp (the USMCA) at risk. We know Republicans in Congress are uneager to open another battle front and may fight the President on enforcement of these tariffs. Just in the past week, several key Republicans (Charles Grassley and the President’s trade adviser, Peter Navarro) have come prepared with a wish-list of potential actions Mexico could do to avert tariffs. The negotiations on this threat are still very much in progress and it is too soon to know if the June 10th deadline will be reached with a new concessions or extensions. However, one thing made clear is that the President, despite pressure from his own party, is not afraid of the consequences of instigating concurrent trade disputes with multiple allies.
We have to be cognizant of threats, neither dismissing them nor exaggerating them. It’s worth remembering, for all the ominous headlines, the current trade war has not deeply affected either country yet. Individually targeted companies and industries have borne some pain, but the impact to the average consumer have been mild thus far. The estimated impact (approximately $1,000 dollars of additional cost per household per year if the entirety of various Mexican and Chinese tariffs are enacted) haven’t materialized. Investors are clearly optimistic that the worst case scenarios will be avoided. In the short term, the consequences have been minor and the retaliatory measures haven’t spiraled out of control. We can only hope the long term costs (e.g. weakened diplomatic relations, higher inflation, stalled business development, debt market instability) are similarly limited.