The Silver Bullet | The Art of the Trade Deal

The Sun is dying out. Humanity faces the prospect of extinction in a few centuries, as the star becomes unstable, with Earth too close to its expanding core. Humanity decides to build thousands of engines to move the planet away from its orbit, in a 25,000 year journey.

The Wandering Earth (2019), was one of the most popular movies in China this year, topping over $700m in box office sales – only second to the Avengers.

Unlike some western sci-fi movies, there is no alien invasion, no space marines or giant robots fighting monsters – and no single hero saving the world on a fighter jet. The main plot is a twenty-five generation journey to improve humanity’s chances of survival. One could say it is a product of China’s culture and world view, even more topical in the current context.

The United States recently announced an increase in tariffs on $200bn of Chinese consumer and other goods from 10 to 25 percent, with further increases to come. China responded with its own schedule of tariffs on U.S. goods. Next, the U.S. banned Chinese tech firm Huawei, prohibiting it from buying American parts and components. China responded with a threat to restrict exports of rare earths, a key component in tech equipment and phones.

Together, the United States and China make up 40% of the global economy. What we are witnessing today is not only an economic struggle between the two largest powers in the world, it is a clash between polar opposites in political, economic and philosophical thinking.

This Silver Bullet is a summary of our thoughts and conclusions on the recent developments.

1. Trade wars: the US and China’s administration have different objectives, time horizons and leverage points.

China’s objective is long term, far exceeding that of one electoral cycle. The general aim is for China to develop a larger political and economic role in the world, and grow its economy to a less dependent state from U.S. financial and information systems. Since his re-appointment in 2017, Xi Jinping signaled a departure from Deng Xiaoping’s doctrine based on “hide your strength and bide your time”. “It is time for us to take centre stage in the world and to make a greater contribution to humankind”, he said at his address to the latest China’s Communist Party (CCP) congress.

The US’ objectives could not be more different. The Trump administration’s primary goal is probably to generate consensus into next year’s elections. Trump’s campaign strategy remains one focused on momentum and voter intensity across key electoral groups. This has been a global success story in politics, due to the disenfranchisement of electorates, lower turnouts and polarization in income and opportunity translating in polarized political views.

To appease his high-intensity supporters, including middle to low income voters in the Midwest, Trump wants to generate political wins on jobs, wages and immigration, in line with his pre-election narrative.

In this context, U.S. policy actions have so far been focused on increasing domestic influence, at the cost of reducing the U.S. international footprint. Just three days into his presidency, Mr. Trump withdrew from the Trans-Pacific Partnership. Later on, the U.S. administration threatened to cut up to 40% of U.N. funding, as well as to reduce support for NATO countries spending less than 2% of GDP in defense.

The irony is that these policy actions have opened the door for China to play a larger role across Asian and Pacific countries. China’s Belt and Road Initiative (BRI) now spans 152 countries from Laos to Italy, with infrastructure investments estimated at $1.2-1.3tn by 2027. The projects are usually financed with low-interest bilateral loans, which have often been used to increase China’s political and economic leverage.

In an example of debt-trap diplomacy, China asked Sri Lanka for a long lease on a major port, in exchange for the country’s request to renegotiate its $13bn debt in 2018. In Malaysia, Prime Minister Mahathir bin Mohamad cancelled $22bn of BRI projects, which he claimed were funneled by his predecessors for opaque purposes. Currently, Chinese bilateral loans account for a very large percentage of GDP, especially in African countries. Last year, Carmen M. Reinhart posited that any official data about China’s loans to poorer countries would be an understatement, given these escape monitoring and aren’t included in BIS or World Bank data.

China’s objective is long term, far exceeding that of one electoral cycle. The general aim is for China to develop a larger political and economic role in the world, and grow its economy to a less dependent state from U.S. financial and information systems. Since his re-appointment in 2017, Xi Jinping signaled a departure from Deng Xiaping’s doctrine based on “hide your strength and bide your time”. “It is time for us to take centre stage in the world and to make a greater contribution to humankind”, he said at his address to the latest China’s Communist Party (CCP) congress.

The US’ objectives could not be more different. The Trump administration’s primary goal is probably to generate consensus into next year’s elections. Trump’s campaign strategy remains one focused on momentum and voter intensity across key electoral groups. This has been a global success story in politics, due to the disenfranchisement of electorates, lower turnouts and polarization in income and opportunity translating in polarized political views.

To appease his high-intensity supporters, including middle to low income voters in the Midwest, Trump wants to generate political wins on jobs, wages and immigration, in line with his pre-election narrative.

In this context, U.S. policy actions have so far been focused on increasing domestic influence, at the cost of reducing the U.S. international footprint. Just three days into his presidency, Mr. Trump withdrew from the Trans-Pacific Partnership. Later on, the U.S. administration threatened to cut up to 40% of U.N. funding, as well as to reduce support for NATO countries spending less than 2% of GDP in defense.

The irony is that these policy actions have opened the door for China to play a larger role across Asian and Pacific countries. China’s Belt and Road Initiative (BRI) now spans 152 countries from Laos to Italy, with infrastructure investments estimated at $1.2-1.3tn by 2027. The projects are usually financed with low-interest bilateral loans, which have often been used to increase China’s political and economic leverage.

In an example of debt-trap diplomacy, China asked Sri Lanka for a long lease on a major port, in exchange for the country’s request to renegotiate its $13bn debt in 2018. In Malaysia, Prime Minister Mahathir bin Mohamad cancelled $22bn of BRI projects, which he claimed were funneled by his predecessors for opaque purposes. Currently, Chinese bilateral loans account for a very large percentage of GDP, especially in African countries. Last year, Carmen M. Reinhart posited that any official data about China’s loans to poorer countries would be an understatement, given these escape monitoring and aren’t included in BIS or World Bank data.

China has been also been gradually weaning off its dependence on USD financing, as it expands its local currency financing markets. Renminbi bonds are now the third largest market in the world with $12tn in value, even though over half is still represented by national and local government bonds as well as policy bank bonds. Chinese bonds now make up six percent of Barclays’ Global Aggregate Index. The expansion in domestic financial markets has the two-pronged purpose of attracting capital for China’s expansion strategy, but also to make its markets less vulnerable to the Dollar and New York Law instruments, which remain ultimately under U.S. control.

China has also been expanding its military reach. In 2017 it opened a permanent People’s Liberation Army (PLA) military base in Djibouti, while expanding its reach in the Pacific Islands, long controlled by the U.S. Navy through its base in Guam.

China has been also been gradually weaning off its dependence on USD financing, as it expands its local currency financing markets. Renminbi bonds are now the third largest market in the world with $12tn in value, even though over half is still represented by national and local government bonds as well as policy bank bonds. Chinese bonds now make up six percent of Barclays’ Global Aggregate Index. The expansion in domestic financial markets has the two-pronged purpose of attracting capital for China’s expansion strategy, but also to make its markets less vulnerable to the Dollar and New York Law instruments, which remain ultimately under U.S. control.

China has also been expanding its military reach. In 2017 it opened a permanent People’s Liberation Army (PLA) military base in Djibouti, while expanding its reach in the Pacific Islands, long controlled by the U.S. Navy through its base in Guam.

2. The cost: China is prepared for a prolonged conflict.

There is no winner from a trade war, especially if it escalates to a global scale. The impact estimates vary from -0.1% of GDP growth shaved off the global economy for a conflict limited to bilateral tariffs, up to over -1% for a global escalation, which would imply chances of a recession.

While the framework of a deal could be reached quickly, both sides seem to be preparing for extended negotiations. At its core, the standoff is a battle between China’s economic and political objectives in the world, with the U.S. trying to both score short-term wins before elections as well as reining in China’s long-term ambitions. Some Chinese analysts compare this threat with the 1985 plaza accord and the following trade tariffs imposed on Japan: Japan went from 70% the size of U.S. GDP to a much smaller fraction over the following decade.

From our recent conversations, the bad news is that both sides think they are winning. The U.S. believes it has dealt a major blow to China with the Huawei ban, which saw support from major western telecom companies. China, however, has been bolstering political support for a new long march, evoking Mao Zedong’s Red Army retreat to the North of the country in 1934, which allowed him to recuperate and rebuild.

There are no winners in an extended trade-war, but there are countries which may suffer less or temporarily benefit from the re-routing of trade, and the U.S. securing alternative sources of imports, reducing its dependence on China. These include Brazil, for example, Mexico and Argentina, as well as Vietnam and Indonesia. Brazil and Argentina benefit from being allies both to the US and China, giving them leverage through their agriculture production and the ability to reduce the risk of a spike in food-inflation caused by tariffs or food shortages, like the recent swine fever in China. Mexico, as well, could benefit temporarily if trade conflicts in China result in greater demand from the US for Mexican goods. Europe, instead, is likely to be hit further, with the U.S. potentially moving to introduce sanctions on cars, also using automakers to gain leverage for negotiations on agricultural products, where the Trump administration hopes to boost exports.

3. Implications for markets: dovish policy pivot to continue.

Last year, investors reacted to US-China policy tensions with a sharp selloff in global stocks, while long-term yields remained high as the Fed kept its hawkish rhetoric. Today, risk assets have held up better and remain above December lows: the key difference has been a global shift in central bank reaction functions and a decline in inflation. The Fed’s dovish pivot was followed by the ECB, the RBA, RBNZ, RBI and the CBR. More central banks which sounded hawkish last year are changing tack. Bond markets are now pricing nearly three Fed cuts by the end of the year.

This does not mean risk assets have been immune to trade war risks. Financial markets are in the process of balancing negative trade news with more central bank liquidity. Analyzing the performance of Q1 2019 credit and equity markets, we conclude that returns this year have been led by duration and low-beta, variables influenced by central bank liquidity. In credit, European triple-B and double-B bonds have outperformed lower rated bonds by a record. U.S. high yield spreads are back above 400bp, implying nearly a 20% default rate over a five years.

In our view, central bank policy will have to remain dovish for a long time in the U.S. and even more in countries with a build-up of structural private and public debt imbalances. These include the Eurozone but also Canada, Australia, New Zealand and Sweden, previously deemed as safe havens from the crisis. Our estimates show the current environment remains one of kick-the-can economics, positive for rates, negative for equities and still positive for credit.

We have been long duration since last year, and continue to receive rates: we see the most upside in Australia, an economy which is both still very dependent on China exports and capital inflows, and which has developed deep private debt overhangs. As house prices start losing steam, Australia’s household debt to GDP ratio stands at 104%, more than double the amount it was in 1988. We also see flatter curves in Canada, New Zealand and Sweden.

Emerging market rates remain particularly attractive, too. Large markets like Mexico, Brazil and Russia offer real 10y yields in the 3-5% area, vs US essentially at 0. Real rates are still 1-3% higher than they were in late 2016, when US yields bottomed before Donald Trump election. In Ukraine, the 2018 brought about an extreme central bank reaction, and real rates are now in the 9% area. Given the relatively dovish background and the relatively contained EM FX pressures, the market will demand yields closer to inflation levels.

The implications for global equities are likely to be more volatility with a decline in corporate profits, which so far have held up remarkably well. We maintain a short position on U.S. and European equities with highly leveraged balance sheets, as a general hedge to our credit book.

For credit, the key question is whether the trade wars will escalate into a recession and a full-blown default cycle. What we have seen so far, instead, is a trickle-up in stressed situations: companies with existing issues have been getting worse. These include industrial firms in Southern Europe and consumer/holiday operators in the UK, where Brexit uncertainty adds to trade concerns. We maintain a long credit beta stance, but have established credit short positions in firms which we think are vulnerable to the cycle.

4. The Dollar and long term implications.

The recent recovery cycle was marked by the Dollar’s persistent strength, supported by foreign inflows into U.S. fixed income and equity assets. We do not expect the Dollar to weaken in the near term. However, as uncertainty eventually undermines monetary policy decisions and other countries develop domestic financial markets, a secular rotation from U.S. assets into other geographies could be on the cards over the coming decades. This is likely to benefit large emerging markets, not only including China, but also Brazil, Russia and Mexico. It could also be an opportunity for the Eurozone, should it finally be able to control centrifugal forces and strengthen financial markets, establishing a fiscal union. The U.S. is likely to win the battle for now, but the future balance of power will undoubtedly look different from what it is today.