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When elephants fight, the grass gets trampled

Tong Kooi Ong & Asia Analytica
Tong Kooi Ong & Asia Analytica • 9 min read
When elephants fight, the grass gets trampled
(Sept 9): Trade tensions between the US and China have taken on a calmer tone in the aftermath of some intense tit-for-tat retaliatory measures in August. The latest round of import tariffs by both countries went into effect on Sept 1 and the next increas
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(Sept 9): Trade tensions between the US and China have taken on a calmer tone in the aftermath of some intense tit-for-tat retaliatory measures in August. The latest round of import tariffs by both countries went into effect on Sept 1 and the next increases are slated for Oct 1 and Dec 15.

Both countries have just scheduled another high-level talk for early October. Unless a deal is forthcoming, all US$550 billion ($761.2 billion) of Chinese imports into the US and US$185 billion of US imports into China — including, for the first time, crude oil — will attract varying levels of tariffs by year-end.

In addition, the US is also using non-tariff pressure points as leverage, including banning corporates from doing business with Huawei and threatening to force US companies out of China.

Clearly, despite all the tweets, rhetoric and on-off negotiations, the situation has deteriorated over the past one year with little actual progress made on a potential deal.

We wrote about the relationship between the US and China and the difference in mindset and fundamental belief of the Chinese as opposed to the typical Western narratives a couple of weeks back, in the article titled “The mountain does not need the cloud to be majestic” (Issue 896, Aug 26). If our interpretation is right, the dispute is going to stay far longer than we hope.

This week, we include several charts to show why neither the US nor China is under enough pressure to capitulate. Yes, the ongoing trade conflict is wreaking havoc in the global economy — by disrupting supply chains and trade flows, creating currency volatility and hurting business confidence, capital flows and investments. However, the worst hit are not the two protagonists.

The US and China are the world’s two largest economies, with huge domestic demand that will support local manufacturers-service providers and are, therefore, comparatively more insular.

Instead, the pain is most felt by countries that are far more export-dependent, particularly in Europe — where exports have been an increasingly important part of their economies — and Asia as well as smaller, emerging economies. Case in point, manufacturing activities in Japan, South Korea, Taiwan and Malaysia are in the doldrums and dragging on growth while Singapore and Germany are on the brink of a technical recession (see Charts 1 and 2).

The US economy, on the other hand, remains on pretty solid ground — even though 2Q2019 growth slowed to 2%, from 3.1% in 1Q2019. This is attributed, in part, to the fact that manufacturing and trade account for a much smaller slice of overall economic activities. Indeed, even though net exports as a percentage of GDP have risen over the past decade, it remains below long-term historical levels and far lower than that for China, Europe and Asia.

The biggest driver for the US economy is consumer spending, which contributes nearly 70% of GDP. With the unemployment rate at a five-decade low and rising wage growth, US consumers are in a good place right now. Household debt-to-GDP too has been falling since the global financial crisis. Retail sales are relatively robust and consumer confidence is high.

As the world’s primary reserve currency, the US has the unique ability to print money (borrow more cheaply than would have been) and still maintain a strong dollar. The US dollar strength is further bolstered by its positive interest rates, versus negative yields prevalent across Europe. A strong greenback is positive for consumers and buffers against imported inflation.

Similarly, while China’s growth is slowing — GDP grew 6.2% in 2Q2019, down slightly from 6.4% in 1Q2019 — it is still within the government’s target range of above 6% and pretty decent, given the size of its economy today.

The current slowdown is due mainly to previous deleveraging and a crackdown on risky investments and a shift towards slower but more sustainable, quality growth. In addition, the government still has multiple levers to pull.

There is room for fiscal stimulus, especially for infrastructure, and lower taxes as well as further monetary easing to boost the economy. The country’s reserves remain high, giving it confidence to allow the currency to depreciate slightly to partially offset the tariff impact (see Chart 3).

China is far less dependent on exports and trade, contrary to widely held perception. That may be the case in the past, but domestic consumption has been the biggest driver for economic growth in recent years. Net exports as a percentage of GDP has been falling steadily (see Charts 1 and 2),
while domestic consumption has been growing (see Chart 4). This is in step with the country’s long-term strategy — to transform the economy away from over-reliance on exports and towards more sustainable domestic consumption.

There is much room for China to grow domestic consumption, including in lower-tier cities and more rural regions, in which per capita income is low but rising. Consumption as a percentage of GDP is still comparatively low at 39%, and household debt-to-GDP stands at a little over 53% (see Chart 5). The Chinese, especially the younger generation, has shown a much higher propensity to spend — increasingly resembling the American consumer.

In short, China wants a trade deal and would certainly gain from one — but not at any cost. The country has other options to buffer the slowdown. It is harder to predict US President Donald Trump’s next decisions. Meanwhile, the rest of the world suffers.

How will all this end? We see two possibilities.

One, as we previously articulated (in “The mountain does not need the cloud to be majestic”), Trump triumphantly boasts of victory in his trade negotiations with China, whatever the terms may be. And China does not, has no reason to, dispute him, as it does not need to cater to popular opinion or Western media narratives. The US, then, moves to take on Europe and the UK on trade. The headline changes, but many of the contexts remain. He would maintain his hardline reputation, playing to his core supporters in the run-up to the 2020 presidential election.

The second and more desperate possibility is a potential global stagflation. It seems odd to talk about stagflation or inflation in a world that has not seen inflation for consumer goods for a long time and where, at the same time, negative interest rates are increasingly common. We will elaborate on this in a future article. But here is the basic premise.

In the past decade, consumer prices were driven down by the confluence of huge, new low-production centres (such as China), new technologies including digitalisation, new supply chains and efficient logistics.

At the same time, global liquidity went towards inflating asset values, such as housing, stocks and bonds. This came about partly because of increasing wealth disparity. The rich spend more of their wealth on assets than consumables. That is, inflation was in asset prices, not consumer prices.

Should the trade war persist, whether it is between the US and China or Europe or other Asian countries, tariffs will push up the price of imported consumer goods, intermediate and technology components, energy costs and so on. It will disrupt the integrated global supply chain, affecting output and increasing production costs for almost all industries. This will eat into corporate profits and cause the stock market to fall, which will, in turn, dampen consumer spending through the wealth effect.

Already, global capital formation has been on a downtrend and the above uncertainties will further push down investments — and thereby reduce future gains in productivity, employment and wages.

How will countries react to falling exports? Some will impose reciprocal tariffs, but no country can match the might of the US, given its net import position and the strength of its domestic market. Their only recourse is to resort to a currency war, printing money to allow the value of their currencies to fall. Because the US dollar is also the reserve currency of the world and seen as a safe haven, and the risk is too high for the Federal Reserve to resort to negative interest rates, this strategy (to counter any US tariffs) will probably be the most effective — although it will clearly be a race to the bottom, a “beggar thy neighbour” consequence.

The rise in the cost of imports will cause real disposable income to fall, consumer confidence to decline, resulting in lower consumer demand and, ultimately, unemployment. Since it is consumer demand that is holding up the US economy now, the pain to bear will be tremendous for both the US and the world.

Already at negative or close to negative interest rates, monetary policy, as an option to stimulate demand, will no longer be effective. This negative supply shock will most likely need coordinated fiscal policies from the largest countries of the world. That said, it might not come to this.

The stock market, being forward-looking, will pre-empt the pain of escalating trade tensions. And collapsing stock prices, we suspect, will force Trump’s hand — and compel him to revert to the Scenario One option. This is the reality of a democratic system, in which the president needs popular support to be re-elected as opposed to President Xi Jinping, who can make decisions based on long-term objectives.

The Global Portfolio gained 2.2% for the week ended Sept 5, far better than the 1.8% increase for the MSCI World Net Return Index. All the stocks in this portfolio rose, except for Builders FirstSource.

The biggest gainer was Dollar General, up 11.9% after its 2Q2019 earnings handily beat market expectations. We will elaborate more on the company next week. This latest gain boosted total portfolio returns to 10.4% since inception, widening our outperformance relative to the benchmark index. The MSCI World Net Return Index is up 5.7% over the same period.

Tong Kooi Ong is chairman of The Edge Media Group, which owns The Edge Singapore

Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.

This story first appeared in The Edge Singapore (Issue 898, week of Sept 9) which is on sale now

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