What to Expect from the Age of Trade Tensions and Economic Protectionism

US-China trade war escalation since April 2018 has critically shaped global markets. On August 2nd, 2019, Donald Trump announced that the US will impose 10% tariffs on all remaining goods imported from China, effective September 1st. As significant consumer goods products will be affected, any additional costs from tariffs will presumably be passed onto the end consumer.However, the US President Donald Trump later decided to postpone new tariffs on Chinese goods to December 15th.

Shortly after the Trump administration’s surprise announcement, the CNY instantly weakened and broke the previous floor of 7 for the first time in more than a decade. Furthermore, almost immediately afterward the severe drop in value, US officials criticized Beijing for currency manipulation.

On August 23rd, Trump announced he would raise tariffs from 25% to 30% on US$250 billion of Chinese imports, effective October 1st. Additionally, tariffs planned for mid-December on US$300 billion worth of Chinese goods would subsequently rise to 15% from 10%. As a result, the CNY continued depreciating toward 11-year lows and equity markets on both sides of the ocean were deeply shaken.

Is the CNY Depreciation Retaliatory or Market-driven?

The USD has performed relatively strongly compared to other major world currencies, primarily due to the solid performance of the US economy. Global economic uncertainties caused by trade tensions have weighed on emerging Asian market currency valuations, including the CNY. As shown in the graph below, major Asian currencies all manifested similarly after news of additional tariffs surfaced. It can also be seen how unilateralistic and protectionist policies have threatened global economic growth and currency stability.

Emerging Asian Market Currencies Performance After Tariff Announcement

Source: Bloomberg

The last discussion over China’s potential currency manipulation practices occurred in 2015 when the PBOC surprised the market with three consecutive CNY devaluations,knocking over 3% off its value. While there had been strong external speculation on CNY valuation; however, CNY depreciation had a stronger impacted on China’s domestic financial system than on foreign markets.

US-China trade tensions tend to dictate short-term CNY valuations. As the graph below shows, the CNY depreciated relative to the USD at each instance of US tariff announcement on Chinese goods, signifying the strong downwards pressure that tariffs place on CNY valuation.

Historical Performance of USDCNY

 Source: Bloomberg

Does China Want a Weaker Currency?

The Trump administration believes that a weaker currency could help manufacturing-based economies like China combat the cost of rising tariffs. Weaker currencies lead to comparatively cheaper goods when exported, which could subsequently offset price increases brought on by tariff hikes. Contrastingly, goods denominated in relatively stronger currencies like USD that are imported into economies with weaker currencies would inherently be more expensive. Under these conditions, Chinese demand for US-imported goods would be reduced while US demand for Chinese-imported goods would be relatively unimpacted by rising tariffs.

The majority of goods included in the current round of tariffs are primarily consumer products, such as mobile phones, PCs, toys, and clothing. Any additional economic burdens from tariffs could be easily transferred to the end consumer by incorporating additional costs into the final product price. Therefore, US consumers would ultimately pay the cost of tariffs and US companies could lose out on revenues or have profit margins pinched by declining sales.

As such, a depreciating CNY may ultimately be beneficial to end consumers. Furthermore, as many global currencies have been declining against a strong USD, it would be very difficult to definitively conclude is Beijing is purposefully partaking in currency manipulative practices. Additionally, as Chinese authorities have made strides to internationalize the CNY and attract further foreign investment, it is conceivable that any CNY manipulation would have counterproductive effects.

Regardless, there are severe consequences to being charged as a currency manipulator. China must negotiate with the US and IMF to define fair CNY valuation practices – though any IMF investigations and findings would be more symbolic rather than substantive. For example, an annual review of China’s economic policies conducted by the IMF concluded that China took steps in the past year to support the value of its currency after the CNY declined against the USD between mid-June and early August 2018.

Overall, the IMF defined the currency as “broadly stable” over the past year, depreciating by just 2.5% against a benchmark basket of foreign currencies. While the IMF may be unconvinced of China as a currency manipulator, it is unknown how the US may act upon the accusation. There are several US bills that could be triggered by such an accusation; for example, the US government could potentially prevent Chinese companies from bidding on US public sector projects while placing restrictions on private sector investment into China. It could also invite other IMF countries to act upon the accusation in accordance with their individual rules and regulations.

In our view, the most harmful trend within the global economy has been the escalation of trade disputes to financial disputes between the US and China. US-China tension could potentially amplify global economic uncertainty and bring increased tension to the Fed.

US Consumer Spending Appears Uninhibited by Tariffs

As discussed in our previous article “Uncertainty from Trade War Leads to Rate-cut Considerations,” the new tariff regime proposed on the remainder of Chinese goods will hit nearly all consumer products. However, because US President Donald Trump has postponed new tariffs on Chinese goods until December 15th, the impact of these announcements before the end of 2019 will be relatively modest (even after considering for tariff hikes over the weekend of August 23).

It is believed that postponing tariff hikes on remaining Chinese imported goods until December was to avoid harming economic growth and, particularly, to ensure a strong US 4Q sales season. The holiday shopping season contributes significantly to US economic health, with the National Retail Federation in the US estimating that Christmas sales contribute approximately 30% of US retailers’ annual sales and holiday sales normally representing about 19% of annualrevenues. Trump’s new tariff decisions would otherwise cause a major price hike leading into Christmas shopping and result in declining US retail sales figures; however, by delaying tariff until the end of the year, the Trump administration can ensure the availability of cheap Chinese goods for the holiday season and avoid the burden of price hikes on US consumers during the busiest shopping season of the year.

Furthermore, tariff postponement also preserves the currently strong US consumer market sentiment.According to the US Commerce Department, retail sales rose 0.7% in July this year, the most in four months. Additionally, strong consumer outlook is expected to persist through year-end, as more than 25% of consumers announced they plan to spend further on discretionary items. As magnets for consumer spending, retail providers like Target and Amazon experienced robust gains in 3Q19, resulting in surging stock prices.

While there are few signs of a US domestic economic slowdown, wild volatility has rocked global financial markets – only to be exacerbated by continued disagreements between the Trump administration and the Fed regarding suitable monetary policy. The Trump administration continues to call for monetary easing and, while the Fed did cut rates in July 2019, Powell definitively stated that the rate cut was not intended to start a new cycle of easing, rather to serve as a preventative measure against mounting global uncertainty.

Despite weakening corporate investment sentiment, positive US economic outlook remains supported by modestly strong labour market, housing market, and US consumer confidence metrics. The Fed has voiced concerns over the potential impact of global trade uncertainties on the US domestic economy; however, rate cuts will help the reinforce the US economy and reduce the impact of unanticipated global disruptions.

Liquidity Injections Across the Globe

As stated by the ECB, the EU is prepared for further economic stimulation, with a high possibility of the ECB restarting quantitative easing efforts soon. The Bank of England will need to prepare for the mounting risks of a no-deal Brexit and the PBOC, regardless of the outcome of currency manipulation claims, has begun to initiate policies meant to deleverage and stabilize the Chinese economy.

With markets across the globe poised for quantitative easing measures, long-term capital has limited alternatives for risk-free investment outside of US treasuries. Germany’s 30-year bond has shown a negative yield for the first time and recent trade disputes have driven capital to US bond markets. As negative yields spread across the globe, US capital inflows are anticipated to accelerate and further raise USD valuations.

Without Fed reaction to global easing measures, capital inflows may become overwhelming. However, as capital always seeks markets that represent fair investment value opportunities (similar to emerging markets in 2008/09), these inflows, if managed correctly, could ultimately be beneficial for the US economy.