What the Sound and Fury of Trade Rhetoric Signifies for Investors
Published April 09, 2018
With contributions from William Pitkin, Vice President and Senior Equity Research Analyst
Tariff announcements from the US and retaliations from China have splashed across the headlines all week. While these events are noteworthy, we believe investors should keep them in perspective. None of the proposed tariffs have actually taken hold, nor are they likely to do so before June. We remain positive on global growth, yet we are alert to the possibility of second order effects if the situation escalates.
Long Simmering Trade Dispute
The current trade dispute did not come out of the blue but rather from years of developments going back to China’s accession to the World Trade Organization (WTO) in 2001. Combining preferential access to global markets with a formidable labor cost advantage allowed China to overtake Japan in 2004 and the US in 2007, to reign supreme as the largest exporter. China’s economy today is USD 12 trillion, poised on current trends to overtake the US as the world’s largest by about 2025.
Precisely as a measure of its phenomenal success, China can no longer be held to a lower standard. Despite taking steps to lower inbound tariffs significantly, the country in many cases still maintains higher tariffs than some trading partners, including the US. China also restricts foreign investment in its economy and exercises strict controls on capital flows and the exchange rate. Of 62 countries reviewed by the Organization for Economic Co-operation and Development (OECD), China was found to have the fourth most restrictive Foreign Direct Investment (FDI) regime in the world, exceeded only by the Philippines, Saudi Arabia and Myanmar (see Figure 1). The world may be able to deal with restrictions by those small economies, but their imposition in China creates distortions on a different scale — the difference between a nuisance and an existential threat.
Beyond the restrictions on FDI, China has developed an ambitious industrial policy known as “Made in China 2025,” identifying 10 strategic areas where China aims to establish a world-leading presence (see Figure 2). In particular, control over IP and information technology (IT) is a critical priority, given the outsized role of semiconductors in the supply chain for electronics and other finished goods exported out of China. USD 150 billion of investment in the semiconductor industry has been earmarked, including corporate income tax exemptions and discounts, to support its growth over the next 5–10 years.
President Xi has also talked about setting up national champions — effectively state-owned enterprises that would be highly subsidized. These national champions could create massive overcapacity, making the playing field even less level for producers outside of China. With every passing year, as Chinese industry makes progress, the fear is that it becomes harder for everyone else to catch up.
In this context, the US tariff proposal must be understood as an effort to induce China to redress distortive practices, coming from a real sense of urgency within the US administration to respond to a threat from a strategic competitor. In the eyes of our economists, however, President Trump has placed undue emphasis on the US trade deficit with China. A trade imbalance can be a normal response to trade between two countries with different costs of labor. We have argued that the administration runs the risk of weaponizing the USD 375 billion deficit in the run-up to the US mid-term elections,1 with unrealistic claims that it could be reduced by USD 100 billion within a year. We believe the US should center the message on China’s distortive practices and seek to enlist allies in a multilateral quest to alter them. Fortunately, developments over the past few days suggest this may be happening.
Economic Cost of Tariffs
Attempts to restrain trade have real economic costs, which is why economists generally oppose tariffs. Only when countries specialize in doing what they do best can we ensure the most efficient production. Once we start putting up trade barriers, we distort where goods are produced. But tariffs can be appropriate when competitors are not playing by the rules — for example, subsidizing their export sectors through currency manipulation.
The OECD has run simulations to assess the impact if the US, China and Europe raise tariffs on all goods to 10% — back to the levels prevailing in 2001, so within the realm of possibility. This would lead to a 1% decline in global GDP, which is estimated at USD 80 trillion in market exchange rates. GDP in Europe and China would come down by 2% and in the US by 2.5% — a sizable impact across global economies. No trade action taken so far comes close to constituting such a macroeconomic event.
Tariffs are not the only tool deployed by the US. Along with initiating a WTO complaint, the Trump administration is seeking to limit Chinese investments in critical and sensitive technologies like semiconductors and 5G wireless communications. To enforce strict reciprocity on acquisitions, the White House has invoked laws reserved for national emergencies2 to block Broadcom’s USD 117 billion hostile takeover of Qualcomm, citing credible evidence of a national security threat if the US loses 5G network leadership, as well as Broadcom's relationship with Huawei — China’s national champion for telecom networking and a long-time security concern.
Implications for Markets and Portfolio Positioning
Equity markets have been buffeted badly by the trade rhetoric coming out of the Trump administration. We suspect the sell-off might have been overblown, reacting less to actual measures and more to fears of potential escalation. There is bound to be volatility while this tension plays out, but after the market’s unusual complacency in 2017 — with just eight days of 1% up or down moves in the S&P 500 Index — we may be getting back to normal levels of market sensitivity to such exogenous events.
In our tactical portfolios, we have been positively allocated to growth assets this year based on the strength of the underlying fundamentals. Before we start to pare back our risk appetite, we would need to see these trade tensions materially impact the environment of steady economic growth and moderate inflation that has been so conducive for corporate earnings.
Understandably, uncertainty over the extent and severity of forthcoming reactions from China or US allies has affected market sentiment, so we remain on our guard in active equity portfolios. Our holdings in China are mostly local in content, and we avoid US companies with meaningful exposures to rising tariffs on Chinese products, while closely monitoring those with deeper ties to China — for example, Nike and Walt Disney — that would feel the brunt of any nationalistic move in retaliation.
Across our portfolios, we are on the lookout for second order effects in trade-sensitive emerging market and Japanese equities, given their vulnerability to China’s policy responses. Over the next two to three years, we may see Southeast Asian nations like Vietnam continue to evolve as more enticing destinations for FDI.
US–China Relationship Too Important for the Two Countries — and for the World
Ultimately, we do not see the current trade spat descending into a trade war. The imposition of the steel tariffs taught us that final outcomes can be quite different from initial announcements. Similarly, much can happen in the nearly two-month negotiation window.3 While recent developments clearly mark an escalation from the past and heighten the risk of an unintended misstep, we believe an all-out conflict is in neither negotiating party’s interest. This is too important a relationship for the two countries and for the world to be taken lightly.
The views expressed in this material are the views of Esther Baroudy, Simona Mocuta, Chris Probyn through the period ended April 3, 2018 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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 See “Beware the Politics of Deficits and Trade” by Elliot Hentov, PhD, State Street Global Advisors, Spring 2018 IQ Magazine.
 See “US-China Trade Dispute: This Time It’s Different” by Elliot Hentov and Esther Baroudy, State Street Global Advisors, March 21, 2018.