China Takes a Hit, but What is Next?

barbed wire

Escalating trade tensions are injecting volatility into the capital markets.  The US has several short-term advantages over China, but this will likely encourage an asymmetrical response.  

China has threatened to forcefully retaliate after the US for escalating the trade conflict by threatening another $200 bln worth of Chinese goods with an additional 10% tariff.  Previously, Trump threatened to $100 bln of Chinese products.   The initial US $50 bln of US tariffs avoided many consumer goods, and the impact may be greater on the global supply chains than Chinese producers.

China’s markets were closed yesterday for a national holiday.  It came back to a bloodbath.  More than 25% of Chinese shares were limit down today (10%), and 80% closed at four-week lows.  Offshore investors who have been buying mainland shares through the HK-link for the past 29 sessions turned sellers today.

 The Shanghai Composite did not simply trade through the psychologically import 3000 level, it gapped below it, and there was no sign of officials inducing buying, as many expected.  The PBOC injected CNY200 bln via its medium-term lending facility (MLF) even though no loans from the facility were maturing. Today’s operations being the month-to-date injection to CNY403.5 bln, the most since December 2012.  These injections seem to push the odds against another cut in reserve requirement soon.

Although many models see limited economic impact from the escalation of trade tensions, investors are more pessimistic.  Last week, the ECB forecast weaker growth over the next two years.  The Japanese economy contracted in Q1, and while it appears to have recovered in Q2, overall it looks flat for H1.  The US economy likely accelerated here in Q2, but few expect the US fiscal stimulus to put the economy on a sustained higher trajectory.

That said, the US economy is continuing to accumulate symptoms of a late-cycle economy.  The 12-month moving average of non-farm payrolls peaked in 2015.  The 12-month moving average of auto sales peaked in 2016.  Debt stress levels, like credit card delinquency rates, are rising.  The yield curve also typically flattens late in an expansion cycle.  The market is skeptical that the Fed will be able to deliver the hikes that its latest forecasts assume (two more this year and three next year).  Interpolating from the Fed funds futures curve, the market sees three more increases by the end of Q1 19 and leans to the Fed being down.

However, from a tactical point of view, the US economy may be in the best position to manage the heightened trade tensions.  China is a different story.  Officials are trying to encourage deleveraging and squeezing credit.  Aggregate financing in May fell to its lowest level in two years.  Retail sales, industrial output, and fixed asset investment all slowed in May by more than economists expected.

China’s reserve fell in May for the second consecutive month.  Although we suspect this can be largely explained by valuation adjustments.  The euro fell 3.2%.  Assuming 20% of China’s reserves are in euro instruments, the currency adjustment alone can account almost a $20 bln decline in the dollar value, which fell by $14.2 bln  Nevertheless, the Chinese officials want to avoid re-entering the vicious cycle of currency weakness, capital outflows, and weaker equities.

Many observers seem to take the US position at face-value.  Not that trade wars are easy to win, for who has experience in trade wars, but that the US trade deficit gives ironically gives it an asymmetrical advantage.   China cannot simply match the US escalation, so the logic goes, because it does not buy sufficient US goods.

Depending on which country’s data is used, and how reexports to Hong Kong are counted, the US exported $130-$153 bln of good to China in 2017.  To match the upped ante by the US with the second round of tariffs on $200 bln or goods, Chinese officials would to re-tax goods already facing an increased tariff.

Even if one did not want to include China’s ability to frustrate US objective in North Korea, Iran,  or the South China Sea, there are other ways China can retaliate. Moreover, China has shown its willingness to retaliate in seemingly unrelated areas.  Consider how China seemed to boycott South Korean goods after it installed the missile defense system.  Or consider how the dispute over some islands with Japan led to China’s decision to embargo rare earths from Japan and boycotted meetings that Japanese officials attended.

China can take subtle action, which might not percolate to the top of the news cycle but would felt by interested parties.  First in administrative and would include tougher inspections and random checks.  New regulations could be imposed.  Second, China can slow the process of granting licenses for US-based businesses.  Third, China can diversify away from US products and supplier.  That is to say that China’s actions against the US could benefit European and Japanese businesses.  Think Airbus instead of Boeing.

The escalation of trade tensions with China appears to appeal to a broad swath of American voters.  While much of Trump’s agenda has been about rewarding his base, the push against China enjoys bipartisan support and more.  European and Japanese officials have also objected to China’s trade practices.  Chinese officials, cognizant of how isolated Trump may be within the G7, may mistakenly under-appreciate how isolated they are on matters of trade.

There are two perennial arear of potential Chinese retaliation that captures the imagination of many observers and investors:  A devaluation of the yuan and the sale of US Treasuries.   We do not think China weaponizes these because they are blunt instruments and their use could be counter-productive.

The yuan is broadly the mirror image of the dollar.  On a purely directional basis, the Dollar Index and the dollar against the yuan are highly correlated over the past 100 days (0.86) and 500 days (0.91).  The dollar trended from mid-2014 through the end of 2016.  In 2017 the  Dollar Index traded lower, and the dollar fell from around CNY6.85 to about CNY6.40.  The Dollar Index bottomed in mid-February and the dollar’s low against the yuan recorded in late March.  The Dollar Index traded lower in the first part of June before surging in recent days.  The dollar traded heavier against the yuan in H1 June before also rising sharply over the last three sessions (CNY6.3870 to CNY6.4850).  Given our constructive outlook for the US dollar, we look the greenback to rise into the CNY6.60-CNY6.65 area.

How China manages the yuan is a strategic decision and it is unlikely to accelerate the depreciation to compensate for the 25% tariff.  A devaluation of sufficient magnitude to blunt the tariff would likely open the proverbial Pandora’s Box and spur the vicious cycle of outflows and depreciation and set back China’s other strategic goals.  Similarly, selling US Treasuries to punish the US is ineffective. The depth and breadth of the US Treasury market mean that it could and has absorbed modest Chinese divestment.

Remember, the coupon supply the market cope with during a quarterly Treasury refunding is more substantial than China has sold in a given period. China traps itself by having so many reserves.  Even if it could sell its more than a trillion dollar of  Treasuries without pushing the market against it, where would it park the funds?  It will not be able to secure the liquidity, saftey and returns that are avaiable in the US.  That said, China could use its Treasury holdings in a way that could frustrate US policymakers, such as using its Treasury holdings in a securities lending or repo program.