The Weekly - Eagles and Dragons

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09/04/2018
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Equity markets appear confused at the moment, as do fixed interest markets for that matter. 

Hardly a day goes by without another instalment in the trade battle with China instigated by Trump in February.  Commentators are polarised between those on the bear market band wagon who believe tariffs can only be bad for global growth, stoking inflation whilst others believe this is all part of a grand negotiating plan leading to some sort of deal with China.  Whichever way you look at it, it introduces uncertainty and volatility with 1% moves in equity indices occurring very frequently.

At first sight, Trump’s reinvigorated trade policy looks like economic madness from a President who is known for his irrational behaviour.  This is leaving many commentators aghast at his apparent incompetence and catastrophising about where this will lead.  We are starting to think differently.  We have previously said that his statement that China needs to reduce its $375bn deficit with the US makes little sense when it is the US that cannot compete internally, hence the import substitution of steel, aluminium, etc.  However, we now think that actually he is being quite smart, which is something we never thought we would say! 

The US has already announced upwards of $30bn of tariffs on steel and aluminium but then followed this up with exemptions for the EU, NAFTA and others, but not China.  In retaliation, China has announced just $3bn of retaliatory tariffs which looks somewhat of a whimper in comparison.  And that is the point.  The sheer size of the US trade deficit with China puts the US in a very strong negotiating position and if the US and China do get into a trade war, in terms of gross domestic product, China has a lot more to lose, significantly more.

We noticed that when Xi Jinping made his state address the other week about the future for the Chinese economy, he stated, uncharacteristically, that the growth should not be at the expense of other nations, not something the Chinese have historically been concerned with.  Interesting that this should have followed so soon after the messages coming from the Whitehouse.  China still needs the US to power its trade surplus and that matters because that keeps the factories busy and people employed and most importantly of all, the Communist Party in power.  Disrupt that and you have potential political instability and Trump knows that.

If you also consider that the Chinese economy is relatively closed to external brands and businesses and certainly to globalisation influences.  There is very little penetration from western brands and bulge bracket banks such as JP Morgan, Goldman Sachs and the like.  The likes of Apple have a presence but they are far from free to operate and have to play second fiddle to competitors such as Huawei.  Other US exports and their penetration are controlled and strictly monitored lest they threaten domestic, often state-controlled enterprises.  The supposedly free-market controlled economy that is China is an oxymoron of contradiction.  The Chinese have relative freedom to export into the west but it doesn’t work the other way around.

So, we postulate that Trump doesn’t have a dogmatic ambition to commit economic suicide to win votes from his supporters in the under-employed rust belt.  Instead we believe that he is using the threat of Chinese trade surplus destroying tariffs in order to open up the Chinese economy to US exports and he holds a lot of the cards.  If Xi Jinping gets this, then we could see a big boost for the US economy, and the west, as the massive opportunity opens up in China.  However, that also threatens their control over society and their exposure to western culture and most importantly, internet freedoms and democracy.  Trump is potentially opening up pandora’s box in seeking to open up the Chinese economy to US business.  No wonder Xi Jinping wants to remain in power forever – he can’t afford to have any challenge whilst he responds to US tariffs.

Trump is starting a dance with the Chinese Dragon.  He had better make sure the American Eagle has the stomach for it but if it means that the trade deficit is narrowed by the US exporting more to China rather than importing less, then that is a better outcome for the US economy.  First quarter US results will start reporting in two weeks with there being relatively little before then to give this market direction outside of political negotiations and noise.  Fundamentally, the global economy is on a sound footing but that is merely a reason not to be too bearish rather than a reason to be bullish.  Many have predicted that 2018 will be a range-bound year with returns in single digits at best.  It feels to us that this is indeed being played out as the Central Banks try to move to a tightening phase without disrupting economic momentum.  The jury is out which is capping market progress whilst there has been early evidence of weakening consumer confidence and spending in the first quarter.  Many are dismissing this as seasonal and nothing to take too much notice off but what if it is the start of a softening cycle. The weeks ahead will reveal more as we progress but in the meantime, caution appears to be the most attractive strategy just in case.

US equities hit by trade concerns and mixed Labour Report

Increased trade tensions between China and the US continued to dominate sentiment during another volatile week that saw the S&P 500 lose -1.4%. Stocks moved lower in early-week trading as China and the US announced tariffs and counter-tariffs on each other’s aluminium, steel, and agricultural products in ‘tit-for-tat’ levies.

US sentiment may have also been impacted by a mixed Labour Report on Friday. Non-farm payrolls data saw just 103,000 jobs created in March, far softer than consensus expectations for the month. Whilst disappointing on the face of it, this was mitigated by upward revisions to previous months leaving the three-month moving average at a healthy 201,000. The unemployment rate was unchanged at 4.1%, a 17-year low. The closely watched year-on-year wage growth also ticked up to 2.7% which is supportive of the Federal Reserve’s tightening policies, given its inflationary connotations. The yield on 10-year US Treasury’s rose following the report, although it was also sensitive to trade rhetoric and geopolitical concerns, closing the week just 3 basis points higher at 2.78%.

European markets fared better with most major indices making modest gains. The UK’s FTSE 100 climbed +1.8% during a holiday-shortened week despite worse than expected data in the UK’s dominant Services sector which accounts for almost 80% of the domestic economy. The latest Purchasing Managers’ Index (PMI) data, a measure of business activity levels, showed a fairly steep drop in the Services sector from 54.5 to 51.7 (above 50 indicates growth). The fall was widely put down to the heavy snow across most of the UK during March.

In commodity markets, the price of oil finished lower on Friday to finish a turbulent week amid trade concerns; China and the US are the world’s two largest oil consuming nations.  Sentiment has also been impacted by some company specific reports in the US that appeared to indicate increasing levels of production. Brent Crude oil slipped -4.5% over the course of the week to a shade over $67 per barrel.

The Week Ahead

The British Retail Consortium releases its latest sales data tomorrow ahead of the official government figures next week. Considering the fact that the country was brought to a standstill by several bouts of heavy snow, the data could well be distorted and not a true reflection of the underlying trends. Manufacturing production data released on Wednesday is likely to reaffirm the weakness reported in last week’s PMI figures. Following on from last week’s Labour Market Report, the US Federal Reserve will turn its attention to the latest CPI inflation figures which are due on Wednesday. The US Central Bank will also release the minutes from its most recent FOMC meeting later on that day. The European Central Bank also releases policy meeting minutes later in the week with data focus likely to be on Thursday’s industrial production and Friday’s trade numbers. Chinese trade is also likely to receive plenty of attention with the latest export and import figures out on Friday. Once again, Japanese data is in short supply although Bank of Japan Governor Haruhiko Kuroda is presenting at the central bank’s quarterly manager meeting. Traders will no doubt be seeking some clues regarding the future path of monetary policy.