From haggling over the price of tea on a quayside in Guangzhou in 1784 to trading in electronics and t-shirts today, over the course of more than two centuries, trade between the US and China has grown beyond imagination. This trade relationship is now the most significant in the global economy.
The world’s two largest economies account for 40% of global GDP, a quarter of all exported goods, and 30% of the world’s Foreign Direct Investment (FDI) outflows and inflows. Their fates are inextricably linked. In a way, they complement and need each other. The US cannot compete with China when it comes to manufacturing and China cannot compete with the US when it comes to product design or research and development capabilities.
The world’s most cost-competitive and largest electronics industry supply chain is in Shenzhen, China. China’s manufacturing capacity is so well honed and organised that it accounts for more than 25% of global manufacturing. It is my firm belief therefore that there will be no US-China trade war on the scale that may worry us all – and tariffs are just a negotiating tactic, albeit a necessary one. I see China opening itself up more to US exports. The US-China trade deficit will start to close meaningfully when the prosperity of China’s middle-class increases and they demand services that the US can export to China. Therefore, it is not just in the US and China’s, but also in world’s interest, that a China –US trade war is averted
Trading with China: From tea to t-shirts
It was a frigid morning on February 22, 1784, also the 52nd birthday of George Washington, who five years later would become the first President of the United States. Two ships – Empress of China under the American flag and Edward under the British flag, set sail from New York harbour on two different but historic voyages. The United States had been an independent nation for only five months. The Treaty of Paris signed the previous September had concluded the war with Britain and freed American businesses from trading restrictions placed on them. America was free to trade with anyone it pleased and the first focus was on China, in order to satisfy the country’s urge for tea and other commodities.
This ambitious young nation, desperate to forge trading links with the Middle Kingdom, had no time to waste. US merchant ship Empress of China set off down the East River, past a 13-gun salute (one for each of the states that were then united) on a fifteen-month voyage to China. Destination: Canton (modern Guangzhou) and carrying a full load of cargo – ginseng, lead, silver coins and woolen cloth. The merchants aboard the ship dreamt of riches to be made by bringing back tea from China. On the very day that the Empress set sail, the Edward, a ship bound for London, departed from the harbour to deliver the congressional ratification of the Articles of Peace between the United States and Great Britain. The Empress set in motion the US-China trade relationship that is now the most significant in the global economy. The world’s two largest economies account for 40% of global GDP, a quarter of all exported goods, and 30% of the world’s Foreign Direct Investment (FDI) outflows and inflows. Their fates are inextricably linked.
American Historian Eric Jay Dolin in his book When America First Met China writes that trade with China quickly became a US national priority and, between 1784 and 1833, there were to be at least 1,352 officially acknowledged visits by American ships to China. Ships plying the seas between the United States and China helped build vast fortunes for US merchants in New York and New England. Many became millionaires overnight and ploughed their riches into shipbuilding to build an ever-faster ship to conduct more trade with China. The money also went into building America’s infrastructure – including banks, canals and railroads and set up wealthy American dynasties such as Astor, Forbes and others. Fashionable Americans coveted all things Chinese. President George Washington and his wife Martha filled their home with the finest chinaware. Tea had been an American obsession since the mid-seventeenth century and although the Boston Tea Party in 1773 led to many Americans giving up tea as an unpatriotic beverage and turn to coffee, the majority still craved for tea.
However, trading with China came at a cost – a trade deficit. America didn’t have much that China coveted. Then, as now, America imported more from China than it exported. From haggling over the price of tea on a quayside in Guangzhou to trading in electronics and t-shirts today, over the course of more than two centuries, US-China trade has grown way beyond any 18th Century imagination. Today, US-China trade in goods is worth $578 billion (with the trade balance in favour of China by $347bn).
So can the US-China trade deficit be bridged? If not, are we in for a US-China trade war?
To date, only three of forty-seven major US trade associations have publicly come out in favor of US President Donald Trump’s new tariff programs, with the balance opposed. In 1987, to rein in the US trade deficit with Japan, US President Ronald Reagan hit $300 million worth of Japanese imports with 100% tariffs for Japan’s failure to open its market to US semiconductors. The US could do that to Japan because Japan was, and is, a US protectorate, China is not. The British solution to its balance-of-trade crisis with China in the 19th Century, was large-scale illegal opium trading and, when that didn’t work, Britain embarked on one of the biggest thefts of intellectual property to date – stealing Chinese tea plants, as well as Chinese tea-processing expertise, in order to create a tea industry in India. Not sure that’s an option today…
The US and China, in a way, complement and need each other. The US cannot compete with China when it comes to manufacturing and China cannot compete with the US when it comes to product design or research and development capabilities. Apple’s iPhone is a product of US engineering talent and Chinese manufacturing prowess, with each phone carrying the line “Designed by Apple in California. Assembled in China.” The world’s most cost-competitive and largest electronics industry supply chain has taken shape in Shenzhen, China. There are more than 700 suppliers of Apple’s iPhone and computer products in the world, nearly half of which are in China. China is playing an increasingly important role in the global supply chain. China’s manufacturing capacity is so well honed and organised that it accounts for more than 25% of global manufacturing. China is the leading producer of 220 of the world’s 500 major industrial products and is the only country that has all the industrial categories in the United Nations Industrial Classification.
According to the US-China Business Council (USCBC), in 2015, US exports to China and China-US two-way investment contributed US$216 billion to US GDP and supported 2.6 million US jobs. That’s a lot of jobs for the US to risk. For the US, China is the largest export market outside of North America and an important overseas market for many US products – agriculture, automobiles and integrated circuits. 25% of the aircraft delivered by Boeing are to China. In 2016, Chinese tourists and students in the US spent more than US$51 billion.
It is my firm belief that there will be no US-China trade war on the scale that may worry us all and tariffs are just a negotiating tactic, albeit a necessary one. I see China opening itself up more to US exports.
While the US promulgated the Patent Act and Copyright Act in 1790, the Antitrust Law in 1890; and established the Securities and Exchange Commission in 1934 and the Committee on Foreign Investment in 1975, it was not until 1992 that China established a socialist market economy system. Since then, it has made remarkable progress. Multinationals emerged in the US as early as in the 1860s, where as Chinese multinationals are only a couple of decades old at most. China is determined to engage and play a crucial role in formulating international rules and laws going forward. China’s ambitious trade projects like the One Belt One Road (OBOR) and leadership in the Paris climate Accord are clear signs of intent.
The way I see it, the US-China trade deficit will start to close meaningfully when the prosperity of China’s middle-class increases and they demand services that the US can export to China. China’s GDP/Capita, at $8,200, is one-seventh that of the US. Imagine the upside to world trade if that GDP/Capita ratio were to just double, let alone go any higher. Therefore, it is not just in the US and China’s, but also in world’s interest, that a China –US trade war is averted.
Markets & the Economy
The key concern for the market is clearly around the US trade tariffs on China. Although China’s Commerce Ministry reacted angrily to Trump’s tariff announcement, Chinese officials have been careful not to escalate the fight. In rolling out tariffs on $3 billion of US goods, China carefully left out the biggest US exports to China – soybeans, sorghum and Boeing aircraft. This, as I have pointed out in the section above, underscores China’s willingness to negotiate a solution with the Trump administration. Any progress in China-US trade talks and indeed China-EU trade talks will be positive for the market. China and other current account surplus nations – Germany, Japan, Korea amongst others, have been looking for specific demands from the US and, so far, have been frustrated over a lack of clarity from the Trump administration. With the US now making specific demands, there is hope that it could lead to a negotiated deal.
Last Wednesday, the US Federal Reserve (Fed) voted unanimously to raise its benchmark Federal-Funds Rate by a +0.25% to a range between +1.5% and +1.75%. Fed Chairman Jerome Powell, in his first news conference as chief, drew high praise for his often succinct and non-academic remarks. He commented that there is still “no sense in the data that we are at the cusp of an acceleration in inflation,” emphasizing that tightening can continue to be gradual. A well-signaled rate rise, which is fully anticipated, like the one we saw last week, eases the anxiety in the markets and gives it more runway and stability.
The Fed delivered a message of strong growth, moderately rising inflation, a healthy jobs market and slightly steeper rates i.e. an outlook that supports higher equity prices. The Fed now expects US GDP growth for 2018 to be at +2.7%, up from the +2.5% predicted in their last forecast as well as an increase in the 2019 growth forecast to +2.4% from their last estimate of +2.1%.
There’s also cheer on the UK economy front. The UK is now running a current budget surplus (the surplus that excludes capital investment) for the first full year since 2001. The UK also saw the fastest increase in productivity in six years, the fastest increase in real wages in three years, as well as falling inflation and record low unemployment. I fully expect the Bank of England (BoE) to raise rates at its May meeting and GBP/USD to trade strong and stay well clear of the 1.40 level, heading to 1.45 by mid-May. The UK and the European Union (EU) have also agreed on a transition deal that keeps UK in the EU until December 31, 2020, easing business fears over a post-Brexit cliff edge. While the UK had to make concessions on the rights of EU citizens arriving to the UK during the transition period, crucially the agreement also confirmed that the UK would be able to sign (but not implement) trade deals with non-EU countries during the transition period. The UK will now be able to negotiate and prepare trade deals worldwide, ready for signing the day after it leaves the EU.
Meanwhile, in Asia, Japan’s economy grew at an annualized rate of +1.6% in Q4 2017, thanks to robust corporate spending in a fresh sign of strengthening domestic demand. Japan has posted its longest growth run (8 straight quarters) in 28 years.
With Mike Pompeo as US Secretary of State and John Bolton as US National Security Adviser, it seems the die is cast for the US to pull the plug on the Iran nuclear deal. Trump explicitly mentioned differences with outgoing Secretary of State Rex Tillerson over Iran in his decision to remove him. I suspect the decision is made already and it will be announced mid-May when Trump has to give his semi-annual approval for the deal, for it to continue for another six months. The collapse of the Iran nuclear deal would be bullish for oil despite the increased oil supply from the US. A tactical long in oil majors (Total, Chevron) and oil services (Schlumberger, Halliburton) could be a good trade to set up.
The Eurozone economy enjoyed its strongest year of growth for a decade last year, growing by around +2.5%, and while the growth expectation for this year was lowered to +2.3%, this is still better than the +1% the Eurozone struggled with for a long time following the financial crisis. European Central Bank (ECB) President Mario Draghi is coming under increasing pressure from a growing faction of ECB officials to start raising interest rates in the middle of 2019. Bundesbank President Jens Weidmann, who is widely tipped to succeed Draghi at the ECB later next year, has been quietly rallying support for the ECB to wind down its Quantitative Easing (QE) program and prepare for a rate rise. Bear in mind, Draghi doesn’t have to yield and he has data on his side. Eurozone inflation, at +1.1% in February, is still far too weak and a strengthening Euro currency as well as possible trade war are all risks.
So in summary, I remain underweight the Eurozone and overweight US equities because of the relative strength of the US economy. My sector biases – Financials (XLF), Industrials (XLI), Technology (XLK) with a tactical long in energy (XLE)
In terms of stocks I like: JP Morgan (JPM US), Bank of America (BAC US), Citi (C US), VISA (V US), Blackrock (BLK), Allergen (AGN UN), Celgene (CELG UW), Gilead Sciences (GILD US), Apple (AAPL UN), Google (GOOG US), Microsoft (MSFT US), Amazon(AMZN UW), Alibaba (BABA US), Baidu (BIDU US), JD.com (JD US), Salesforce (CRMUS), Home Depot (HD UN), Estee Lauder (EL US), Glencore (GLEN UN), Rio Tinto (RIO LN), Freeport McMoran (FCX US), Schlumberger (SLB US), Halliburton (HAL US) WallGreenBoots (WBAUS), CVS Health Corp (CVS US), YUM Brands Inc. (YUM US), BNP Paribas (BNP FP), Barclays (BARC LN), Vinci (DG FP), Eiffage (FGR FP), Pepsi (PEP US), Kraft-Heinz (KFA US)
Manish Singh, CFA
Chief Investment Officer, Crossbridge Capital
Despite its high debt to GDP ratio, Italy’s main problem isn’t that it borrows too much – the issue is its non-existent growth. Italy, the third largest economy in the Eurozone hasn’t grown in any meaningful way for over two decades. Tinkering on the edges and paying lip service to reform mean that the outlook isn’t very bright for Italy. The European Central Bank’s (ECB) easy monetary policy over the last five years, may have pushed the recent GDP growth rate in Italy to +1.5%’ but what will happen when the ECB winds down its Quantitative Easing program and interest rates begin to rise? A re-run of the rising sovereign bond yield and questions about the viability of Italy’s economy are bound to resurface. In terms of equity markets, I don’t believe we have entered a new market regime, despite the recent market move. We are probably entering a transition phase and despite the market rhetoric, it is premature to conclude that the US Federal Reserve is behind the curve. The steady rally up we have seen over recent years may be behind us and what we will see going forward are moves both up and down i.e. welcome back to the two-way market. I still expect the S&P 500 Index to notch an +8-9% return this year – at least 200 points higher from the current level. What I am more concerned about is the rapidly deteriorating political equation in Germany. For the first time, the Far-Right Alternative for Germany (AfD) party has now surpassed the centre-left Social Democrats (SPD) in a national poll. How long before the AfD becomes the largest party in Germany? Inconceivable one might say, but not impossible. As Angela Merkel has moved leftward to occupy the space formerly taken up by the centre-left, the AfD has little competition for anything right of centre.
The all-important 19th National Congress of the Communist Party of China (CPC) kicked off last week in Beijing. In his bold 3 hour and 23 minute address, President Xi Jinping, outlined the party’s priorities for the next five years. If Beijing has its way, China is on a track to becoming an economic power the likes of which we have not seen in a long time. It’s not the Japan of the 1980s, it’s much larger. It’s no surprise then that even the US National Intelligence Council warns that the era of Pax Americana is “fast winding down.” To the Western eye the ascendant power of Beijing may seem a disruption to the status quo, but to students of world history and China, it is the restoration of a millennia-long equilibrium. China was the biggest economy in the world for most of the past 2,000 years, only to be overtaken by Europe in the 19th Century. The ramifications of this Chinese growth are significant. America will almost certainly come out second best if it doesn’t change tack – with Europe a long way behind.
With Brexit and the election of President Trump, a new era is upon us. An era in which the certainties that have held true for decades are suddenly no longer valued. They are vulnerable. Globalization, immigration and liberalism which have defined the last three decades could get undone by protectionism, nationalism and populism. Yes, trade wars could be a reality and, yes, the US and China really could go to war in the next five years. No, their trade relationship will not prevent it. The UKGerman economic relationship didn’t prevent the slaughter at the Battle of the Somme a century ago. However, there is a silver lining. The current populist wave in the US and Europe is not about “pitchforks and soak the rich” and potentially has a positive side to it. Unlike past populist movements that arose from a desire to upend society, today’s movement is driven more by the longing to restore things to the way they were in the “good old days.” In other words, it may have reactionary elements, but it is not truly revolutionary. The grievances if handled correctly, will pave the way for a brighter future. The markets are probably right to think that Trump heralds a friendlier approach to business, in the form of lower taxes and less regulation. The S&P 500 Index (SPX) has been flat since midDecember, as investors take a wait and see approach to the policies of President Trump and their impact on assets.
Hillary Clinton is now favourite to win the US election. If the US economy continues to grow at a pace of +1 to +2% per year (instead of the historical +3% to +4%), then the current economic and political problems will only worsen. Clinton will be acutely aware of this. A growth deficit should be a bigger worry than a budget deficit. Fiscal austerity has to give way to fiscal spending that induces growth. With 30y US Treasurys yielding 2.5%, borrowing to invest should be the mantra. The current economic expansion in the US, which began in June 2009, is now in its 88th month, which means that Trump or Clinton is likely to face a recession early in his or her administration. Equity Bull markets tend to have an expiration date as well: On average every 4.5 years. However, like the economic expansion, this Bull Run is also past its due date and is now seven years old. Does that mean one should sell? Not at all. Seasonally, we are entering the best period for equity markets. November to April is when equities tend to do well, before the May to October swoon. Since 1950, the S&P 500 Index has gained +7.1%, on average from November through April, versus +1.4% from May through October. Monetary accommodation is set to continue. These markets will not be broken by central banks. In many respects the central banks “own” these markets. If anything breaks the market, it will be the upheaval that only politics can cause – the US election, the Austrian election, and the Italian constitution referendum amongst others.
The Brexit vote can be about many things but, at its heart, it’s a vote about the sovereignty of the national Parliament of the UK. Whilst those on the continent (particularly in peripheral Europe), may have come to trust Brussels more than they trust their national Parliaments, at least in the UK sovereignty is cherished and protected. In the eyes of a Brexiteer, the European Union (EU) undermines that sovereignty. I expect the UK to vote (albeit very reluctantly) to Remain in the EU. However, a vote by the UK to Remain should not be construed as an approval of “business as usual.” There was never a necessity for the EU to be anything more than a “free trade” alliance and one can’t deny that the EU’s reach has exceeded political necessity. Whether or not the UK leaves, change is coming. Globally, if loose monetary policy alone remains the saviour, then I am concerned that we may see the next recession in the US in the not so distant future, as job growth slows and drags down with it wages, capital investment and consumer spending. The Negative Interest Rate Policies (NIRP) being deployed by central banks, seem illjudged and a waste of valuable time. Negative interest rates are simply a distraction from what must be done to accelerate growth. The demand has to be injected directly into the economy and not intermediated through the financial markets.
The Facebook IPO has come and gone and it has made Mark Zuckerberg a billionaire – many times over – and a Sucker-berg out of all retail investors who rushed in. Hype is not value. My fair value for a Facebook share is $20; however, I would wait to hear more about the company’s revenue growth plan before buying the stock even if it gets to this level. Greece has proven the point made by Margaret Thatcher about Socialism: eventually you run out of other people’s money. Germany is faced with two impossible outcomes – they take losses on the debt extended so far and suffer from, a rising Deutsche Mark (if the Euro then breaks up), or they tolerate high inflation and bear yet more fiscal transfer, if the Euro carries on as it is. Since it is difficult to work out the cost and benefit of each option just yet; the evidence so far suggests that Germany may be willing to give political integration in Europe a shot. The recent pullback in equity markets globally was primarily driven by the May 6 Greek elections, and fear of a Greece exit (or Grexit). I do not believe either a Greek exit or a Spanish bankruptcy is on the horizon. I am more inclined to believe that further ECB easing and European bank recapitalisation on the scale of the US (think TARP 2008), are the next actions in Europe