Written by RVX Asset Management Equity Investment Team
May 30, 2019
Trade War Concerns
Volatility has returned to emerging market equities given rising tensions around US-China trade negotiations. As the market’s base line expectation was an amicable resolution by early summer, recent events point to an increased potential for a protracted conflict.
What’s happened so far:
The U.S. announced in mid-May plans to increase tariffs from 10% to 25% on $200 billion worth of imports from China, with the possibility of eventually expanding tariffs to all Chinese imports. China then countered by adding tariffs of up to 25% on $60 billion of U.S. imports, with the possibility of additional measures. China also relaxed its monetary policy stance as well as eased fiscal policy, with more stimulus measures to come. In return, the U.S. then barred Huawei (with a 90-day reprieve) from doing business with U.S. telecom companies without regulatory approval, and it is suggesting that allied countries do the same.
What can happen next:
At the next G20 meeting at on June 28th and 29th, Presidents Trump and Xi are tentatively scheduled to meet. There is a high chance of increased rhetoric prior to the meeting, and we expect markets to remain choppy. There is also a possibility that trade talks occur before that timeframe, and U.S. Treasury Secretary Mnuchin mentioned on 5/22 that he expects to visit Beijing “in the near future”.
The U.S. is also considering putting at least five Chinese surveillance-equipment companies on the same blacklist as Huawei. In another move that could target China, the Commerce Department mentioned on 5/23 that it was considering a rule to put anti-subsidy tariffs on products from countries that undervalue their currencies.
Chinese exports fell 2.7% year-over-year in April, even prior to the new U.S. tariffs. The tariff implications might include:
- Lower prices for Chinese exporters to offset the additional cost imposed to their products, making them more expensive and less competitive.
- Higher prices for US importers and consumers due to import tariffs.
- Lower margins for all businesses involved.
Additionally, trade tensions and Chinese retaliation may only worsen the current weak economic scenario in China and impact overall global growth estimates.
If it escalates:
- A further decoupling of the Chinese and American economies is possible, including a dismantling of the supply chains both countries depend heavily. 60% of all goods imported into the US from China are made by non-Chinese companies. These companies will either have to absorb the tariff increase or pass it along to US consumers (or a combination of both). These companies may also get into the cross-hairs of Chinese regulators, who may make it especially difficult for US companies (Apple, Starbucks, Boeing etc.) to do business in China.
- The anti-Japan sentiment in China during the Senkaku Islands dispute in 2012 and the anti- South Korea sentiment during the THADD standoff in 2016-17 did considerable damage to the equities of Japanese and South Korean multinationals that were operating in China. Depending on the manufacturing base and percentage of profits from their Chinese operations, the equities of some US multinationals may decline accordingly.
- China is the largest foreign creditor to the U.S., with total Treasury holdings over $1.1 trillion (7% of all outstanding). It was perhaps not a coincidence that China had the largest amount of Treasury sales in over two years immediately after trade tensions ratcheted up in mid-May. Regardless, we would not expect this area to be weaponized by China. US Treasuries are some of the most liquid and safest securities in the world, and given the low yields in Germany and Japan, China has very few other options on where to park its money.
- China is the global leader in rare earth materials, which is a key component in global supply chains. These materials are used in disparate products such as iPhones, oil refining, missiles, and wind turbines. China could ban or increase tariffs on exports into the U.S. We also think this is a low-probability event as China would itself be harmed by the ensuing prices increases in the raw materials.
Short-term investment implications:
We would assume if the rhetoric starts to impact the stock market or the real economy in a negative way, Trump will back off. Aside from tariff-related issues, we see reasons why any further CNY depreciation would likely be limited and gradual. So far, the evidence shows that China has been lowering rates and depreciating the yuan from 6.3 to 6.82 vs the USD, allegedly to partially offset the negative consequences of potential US tariffs on their exports. We believe that the end-2016 level of 6.96 could be the maximum that the PBoC allows it to go. The USD/CNY 7 level is probably a threshold for China to be called an FX manipulator, as the CNY started weakening since April 21st but has not reached previous lows yet.
Given the newsflow around Huawei, we would expect China to accelerate plans to become more self-sufficient in semiconductors. Domestic-oriented sectors in China should be fairly insulated and may even benefit from increased government stimulus. In the meantime, Korean companies such as Samsung may stand to benefit from being a non-US supplier. Southeast Asia may benefit as multinationals may look to new countries to circumvent the trade war; Vietnam could be an especially attractive destination for new factories. Brazil and Argentina’s grain exporters may also stand to benefit as new partners.
Long-term investment implications:
Given the timing of US elections in late 2020, China may decide to play the long game to see if the current US administration gets re-elected. China has a ‘national team’ of state-owned enterprises, banks, and brokerages that are ready to step in to backstop the equity and currency markets. China also has no opposition party and a friendly media apparatus. In recent speeches, President Xi has alluded to a new ‘Long March’, invoking a time of hardship and austerity for the Chinese people. The Long March refers to a grueling 4,000-mile journey taken by the Chinese Communist Party in 1934 as they fled the Nationalist Army under Chiang Kai-shek. When they regrouped and reclaimed China in 1949, the Long March became a key inflection point in the Party’s history. All signs are pointing to the Chinese getting prepared for a protracted trade conflict with the U.S.
As this plays out, defensive sectors and more value-oriented investments have a higher chance of long-term outperformance. India and Indonesia also look to be favorable markets to get emerging markets exposure without trade war concerns. Both countries may embark on ambitious domestic initiatives, which would include further infrastructure growth and urbanization. Demographics in both countries will be favorable for many years, and GDP growth should remain above global averages.
Our base line assumption is that a trade deal gets done by the G-20 meeting at the end of June, giving both sides the opportunity to save face and please internal constituents. Longer-term, trade negotiations may just be the first volley in a broader economic, trade, technological, and geopolitical realignment of power between the US and China. While this argues for a more defensive posture, emerging markets investors should note that the asset class is broad and there are many attractive regions outside of China. Any further volatility in the asset class should lead long-term investors to a greater overall opportunity set.