Is the trade war really all about the mid-term elections?

Mid-term elections

US President Donald Trump’s trade war could damage the global economy, but is he just playing politics?

Steve Mnuchin did not hold any formal meetings with China at this weekend’s meeting of G20 finance ministers in Buenos Aires. This is despite the US Treasury Secretary indicating recently in Congress that he was prepared to reopen talks on trade issues if Beijing was willing to pursue “serious efforts to make structural changes” to its policies. This snub is a concern to investors hoping that the issue could be wrapped up in the next few months. Many in the market think that the current machinations are aimed at galvanising support behind the Republican Party ahead of the key mid-term elections. This is the “base case” for many investors – but are we being too complacent on the issue? Will Trump really back down to stop markets being hit?

Last week, US investment bank Citigroup became the latest to express its belief that the issue will be resolved over the next two months. “US trade actions have been brutal and unilateral and have punctured the trust built up over decades of good-faith agreements,” the bank said. “Our base case is for negotiations to continue and for trade deals to be done ahead of the November US midterm elections.” No substantive talks were held this weekend, but Mr Mnuchin said on Sunday, adding: “Any time they want to sit down and negotiate meaningful changes, I and our team are available.”

Both sides have now implemented tariffs on $34bn (£26bn) of each other’s exports. China has targeted Trump-voting states, placing duties on soya beans, meat and vehicles. The US is particularly concerned about technology transfer – and for good reason. The global dominance of the US – and its equity markets – is based on its technological achievements. It’s not just Nasdaq that is tech-heavy – technology related businesses make up more than a quarter of the S&P 500 by weighting. Innovation is the driver of US hegemony.

So far, equity markets have taken this threat relatively well. However, last week the International Monetary Fund (IMF) warned of “complacency” over the issue. It said that the escalating trade confrontation is the “greatest near-term threat to global growth” and in the worst case could cut 0.5% off global GDP. With global growth expected to be in the order of 3% this year, this could actually be a price worth paying for President Trump to galvanise his base.

Indeed, President Trump is now threatening to impose 10% tariffs on $200bn of other goods from China. Should this come to pass – it is currently going through a legal consultation in the US – then the impact on market sentiment could be significant. We have already seen sharp falls in the price of copper, which is down almost 18% since early June. The metal is regarded as a key indicator of the global economy because of its wide range of uses. Soya beans, which have been targeted by China in the first round of retaliation, are down almost 19% in price since late May. Any escalation of the trade war is likely to see such falls spread into other markets, as sentiment will rapidly turn sour.

Chinese growth is a major driver of the global economy, accounting for about 16% of global GDP in 2017 and Citigroup has calculated it is responsible for 35% of global growth over the last five years. Growth in the country has been moderating for some time, but it appears that exporters to China are now starting to bear the brunt of this slowdown. This week we saw GDP growth ease to 6.7% in the second quarter from 6.8% in the first three months of the year, its slowest rate of growth since 2016. A significant amount of this easing is down to a deliberate tightening of financial conditions, as authorities attempt to tackle excessive credit and bad loans. There is a concerted effort to deleverage parts of the corporate sector, and to rein in the shadow banks that have undertaken substantial risky lending in recent years. This is what has been driving the slowdown so far.

Fortunately, we are already seeing signs of some compromise from Chinese authorities. They are downplaying its contentious Made in China 2025 policy that is targeting Chinese leadership in robotics, biotech, aerospace and clean-energy vehicles. This attempt to move the country up the value chain by transitioning from labour-intensive industries to “smart manufacturing” has really stoked the current US administration’s ire. To ease fears that the project aims to replace foreign companies operating in China and then take them on globally, authorities have said that the policy is open to participation by non-Chinese businesses too. However, the Chinese Ministry of Finance has said that Made in China is actually open to foreign companies. It has also announced an easing of restrictions for pharmaceutical companies, financial services and vehicle manufacturers. But are these compromises enough?

A trade war-induced slowdown in GDP growth is the most important downside risk to equities over the coming months. However, it is clear that Donald Trump and Steve Mnuchin watch markets closely to assess the impact of their words and deeds. This is why the most likely outcome remains some sort of resolution before 6 November. However, political risk for investors clearly remains elevated.

 


The above article was previously published by Charles Stanley on 23rd July 2018