By Jay Roberts
When Presidents Donald Trump and Xi Jinping met for the first time at Trump’s Florida golf retreat, Mar-a-Lago, in April 2017, it was all smiles and bonhomie. China’s official Xinhua news agency sounded a note of triumph—even despite Trump informing an unsuspecting Xi that he had just launched 59 missiles at Syria over a “beautiful piece of chocolate cake”—declaring the meeting as positive, fruitful, and a new starting point for the world’s most important bilateral relationship. Trump lauded his friendship with Xi and described the relationship as “outstanding.” Progress indeed from the campaign trail comments in 2016.
Since then, and noted in various Global Insight publications in 2018, the China hawks in the Trump administration have steadily gained the ascendancy. The Trump administration moved quickly from words to actions. To date, this has culminated in five percent–25 percent tariffs on US$250B of goods from China with further increases in tariffs planned for January 2019. China has responded in kind with $160B of its own taxes on U.S. goods, steadfastly underlining its self-belief as a global power that will not kowtow.
U.S. dollar/Chinese yuan exchange rate
Source - RBC Wealth Management, Bloomberg; data through 11/8/18
Chinese equity markets have declined deep into bear market territory, although this is amid a backdrop of Chinese policy aimed at financial deleveraging, a clunky term that simply means tackling riskier areas of lending in the economy. China’s currency has weakened. More recently, it is beginning to dawn on global investors, including in the dominant U.S. market, that what is happening between the U.S. and China goes far beyond political posturing. Something far larger is afoot.
As Trump accused China in September of interfering in the U.S. midterm elections,1 he offered that President Xi “might not be a friend of mine anymore.” An understatement, perhaps. How things have changed.
What is going on is much more than a trade dispute. It is primarily a national security dispute where the key ingredients are: technology leadership; laws, regulations, and behaviours; an overarching accusation of state interference; and ideological differences.
All U.S. presidents are required to produce a National Security Strategy. Trump’s was produced in December 2017 in record time. Of note: “China and Russia challenge American power, influence, and interests, attempting to erode American security and prosperity. They are determined to make economies less free and less fair, to grow their militaries, and to control information and data to repress their societies and expand their influence.”2
The complaints in the U.S. Trade Representative report from March 2018, ordered by Trump in August 2017, revolve around China’s alleged theft of intellectual property, forced technology transfer, limited market access, and state-sponsored cyberattacks.
As such, it is nigh impossible that all will be resolved in a brief meeting and a handshake between Trump and Xi. At most in the short term, there may be some agreement to postpone tariff increases, for example, or agree to rejoin negotiations (currently minimal). But the U.S. has said that it now refuses to negotiate until China presents a concrete plan on technology.3
Moreover, while the dispute has been intensifying over the past year, it has really been many years in the making. The Obama administration discussed similar issues. Even today, with the divide between Republicans and Democrats widening to a chasm, the issue of tackling China is a rarity in that it enjoys unfettered bipartisan support, including some of Trump’s most vocal critics in the Democratic camp.
The U.S. long believed that engagement with China would bring about desired changes over time. That belief is being ditched. Plan B is in operation and it does not only include tariffs.4 China has responded by refusing to bend publicly. State media labelled U.S. methods as “extreme blackmail.” Xi Jinping gave a speech at a trade fair in Shanghai on Nov. 5 proclaiming a “new round of high-level opening up.” He also commented that the free trade system is under threat and levelled some thinly veiled criticisms at the U.S.
Crossing the Rubicon
Along the way, there have been a number of public comments made by U.S. officials that underline the seriousness of the situation and the commitment of the U.S. to a new strategy.
The most strident was a speech—history might term it the speech—delivered by Vice President Mike Pence on Oct. 4 in Washington.5 Over the course of 40 minutes, Pence delivered a stinging rebuke to China across a wide range of issues that went well beyond trade. The combination of its smorgasbord of complaints and accusations across multiple spheres including commercial affairs, political ideology, military expansion, and human rights; the length of the speech; the entire focus on China; and the fact that it was delivered by the second-highest U.S. official make this a moment in which the U.S. may have finally crossed the Rubicon. For its part, China questions its role in a unipolar world subject to U.S. hegemony.
The nature of the strategic relationship between the U.S. and China is undergoing a generational sea change, in our view. We expect this divergence to continue as both countries work to remove some interdependencies over time. There is growing mistrust on both sides. We believe that the process will be protracted and peppered with bouts of real tension.
Economic implications & market response
The U.S. is primarily a domestic, consumer-driven economy. If economic measures are restricted to tariffs of moderate levels, we believe the impact on the U.S. should be manageable during expansion periods. However, unpredictable secondary actions, such as restricting market access in China or imposing a series of harsh sanctions, would be more damaging to certain companies, in our view. Additionally, the inflationary effects of tariffs are unclear—at a time when U.S. bond yields are pushing higher on Federal Reserve rate hikes and strong economic data.
For China, the impact of a full-blown trade war would be more pronounced, perhaps reducing growth by up to 0.7 percent, according to one estimate by the Chinese government. However, the Chinese economy is also more consumer- and services-oriented than many people might think, in our view.
Equity markets in China, Hong Kong, and to some extent elsewhere in Asia have responded rapidly and negatively since the first tariffs hit. Hong Kong’s Hang Seng Index has declined in eight out of 10 months in 2018. MSCI China Index earnings have been revised downwards for six consecutive months. This trend needs to halt before investors can become more constructive, in our view.
Major Asian equity indexes: 2017 & 2018 year-to-date returns
in U.S. dollars
Indexes shown: Hong Kong Hang Seng Index (HSI), MSCI AC Asia Pacific Index (MXAP), NSE Nifty 50 Index (NIFTY), Jakarta Stock Exchange Composite Index (JCI), Tokyo Stock Exchange Tokyo Price Index (TPX), Straits Times Index (STI), Taiwan Stock Exchange Weighted Index (TWSE), S&P/ASX 200 (As51), Shanghai Composite Index (SHComp), Shenzhen Composite Index (SZComp)
Source - RBC Wealth Management, Bloomberg; data through 11/5/18
Unfortunately for China, the dispute comes at a time of financial deleveraging, which itself is impacting the ability of Chinese companies to tap the domestic capital markets. For example, some Chinese property developers are being forced to offer markedly higher yields on new bond issuances.
We have begun to see Chinese policy support for the equity market. Historically, the actual market has bottomed between one to six months after such support is announced, but every situation is different. While we forecast the Chinese currency to weaken through USDCNY7.00, we believe that authorities would not entertain any disorderly selloff.
The dispute has also meaningfully impacted other Asian equity markets. Some of these markets are approaching levels where valuation may become supportive.
Going forward, a growing divide between the U.S. and China would have ramifications for economic growth rates (although benefits may accrue to other countries depending on the movement of supply chains). However, we believe this is more likely to be an ongoing erosion of growth rather than a shock. For companies, the impact on some will be negligible, for others potentially significant. Investors should consider this when constructing and managing portfolios.
- https://www.whitehouse.gov/wp-content/uploads/2017/12/NSS-Final-12-18-2017-0905.pdf (Page 12)
Non-U.S. Analyst Disclosure: Jay Roberts, CFA, an employee of RBC Wealth Management USA’s foreign affiliate RBC Dominion Securities Inc., contributed to the preparation of this publication. This individual is not registered with or qualified as a research analyst with the U.S. Financial Industry Regulatory Authority (“FINRA”) and, since he is not an associated persons of RBC Wealth Management, he may not be subject to FINRA Rule 2241 governing communications with subject companies, the making of public appearances, and the trading of securities in accounts held by research analysts.