Thursday, July 26th, 2018
The deflection of US President Trump’s sweeping tour of Europe, culminating in a purposeless and controversial meeting with Russian President Putin, will now put international trade friction as the focus for world investment markets.
Cathy Wilcox, SMH
Incongruously the trade friction and the incessant “tit for tat” announcements are coming at the instigation of the US. Whilst the US rightly claims a massive goods trade deficit with China, there is no evidence that this deficit is destabilising the growth cycle of the US economy. Indeed, in this calendar year, it is apparent that the US is continuing to motor along as other economies begin to slow.
The best indication of this growth is the sustained improvement in US employment numbers. The average growth of 200K per month in employment numbers has been maintained for the last 2 years and appears to be accelerating, despite this economic growth cycle being one of the longest in US history.
The sustained US economic growth cycle has also been captured by the powering performance of the US equity market over the last 5 years. However, in recent months (since late January) the performance has been checked by rising interest rates and the trade dispute stirred by bleats and tweets from the US President.
The outperformance of the US equity market is captured in the next chart which tracks the relative performance of the US S&P 500 against the rest of the world indices. The outperformance poses this question – If the trade situation is so bad, then why has the US stock market and the US economy done so well?
The simple answer is that growing international trade and globalisation is still positive in many aspects. Open trade that is based on comparative advantage lifts the standard of living and lowers the costs of goods and services for participants. More importantly, the US trade engagement with China – the fastest growing large economy in the world – has helped and not hindered the US economy. It has certainly helped those US multinationals that can supply into the Chinese market or that have accessed cheap sources of supply of goods or parts.
The growing US-China trade reflects exceptional economic activity in China accessed by US multinationals. Many of these direct beneficiaries do not repatriate their profits back to the US, meaning the US trade deficit is probably overstated.
The next chart is significant for the US and exposes how President Trump’s arguments are totally at odds with factual observation. The benefit of trade that flows from comparative cost advantages has a dramatic downward effect on inflation. The chart shows the movement of US inflation over the last 20 years and tracks the costs of imported goods and those goods subject to foreign competition.
It clearly shows that the prices of goods subject to foreign competition — think toys, television sets, apparel — have tumbled or barely moved in price over the past two decades as trade barriers have come down.
Prices of so-called non-tradeable goods and services (essentially US supplied) — hospital stays, college tuition, childcare, vehicles and housing — have surged. Without trade, inflation (compounding at 2% per annum) in the US would be substantially higher.
Meanwhile, average US wages are observed to have lifted by just 1% per annum above the inflation rate over the 20-year period. The benefits of open trade have been lost through high costs for services provided in the US for the average US citizen. Perhaps this goes part of the way to explain why many US citizens support their President’s trade policy – because a true presentation of the facts are seldom made and the benefits are hidden.
Over the last eight years, a period of strong economic recovery in the US, the benefits have not flowed to the average US worker. The chart below shows that real wages have barely risen. Inflation has mostly offset low average wage rises. Indeed in 2018 (so far), real wages have not moved at all, while significant tax cuts have been advanced to US corporations and wealthy citizens.
Overcoming weeks, major listed US corporations will report second quarter (calendar) earnings. Already reasonable numbers have been reported by major US financials and these have helped lift the US market in the face of the brewing trade storm. However, most of the reported profit gain has been accounted for by the benefits of the Trump tax cuts.
The next chart clearly shows this, with underlying earnings (reported before tax) compared to after-tax earnings or earnings per share. Since the cuts, effective from 1 January, the US market eps has grown by 10% greater than the underlying pre-tax earnings.
In other words, while the US economy has supported earnings growth, the reported results have been turbo-charged by the tax cuts.
The tailwind for US corporate earnings from the tax cuts will fall away in 2019. From that point, it will be the battle between other headwinds and tailwinds that will take over as the major influences on the US economy and equity market. The developing trade war – if not resolved – will be a major headwind.
The influences (including trade) are succinctly summarised in the next table. Arguably the winds or influences have never been so diverse and the weighting of each subject to so much conjecture; however it is our view that trade/tariffs/protectionism rate as the biggest potential headwind.
It is also our view that the headwinds in 2019 will become greater than the tailwinds, particularly if the trade dispute between the US and China does not abate with a rational compromise.
After the first $37 billion of 25% tariffs, another $200 billion in products are under threat for a new 10% duty on Chinese imports into the US such as bicycles, sound systems, refrigerators, pocketbooks, vacuum cleaners, cosmetics, tools and seafood. President Trump has stated that he is willing to impose tariffs if Beijing retaliates again—which would mean that over 50% of what the U.S. buys from China would be hit by duties. China sent $523.7 billion in products to the U.S. last year.
China’s Commerce Ministry stated last week that it “has no choice but to take necessary countermeasures.” However, it is important to understand that China doesn’t import enough from the U.S. to match Washington dollar for dollar with tariffs as it has in previous rounds, so Beijing may review other options. Should it do so it has the capability of destabilising the U.S. economy.
Measures (outside selling U.S. bonds) could include holding up licenses for U.S. companies, delaying approval of mergers and acquisitions involving U.S. businesses and ramping up inspections of American products at China’s borders.
It is interesting to note that under the new “threatened” tariff list, the biggest categories of Chinese consumer-product imports have been spared. The list doesn’t mention smartphones, such as iPhones, or televisions – so, does Apple Inc. have undue influence here? Finished shoes and clothing aren’t included either—about 70% of the U.S. footwear market is made up of Chinese imports. Neither are pharmaceuticals or medical devices.
While a third of all U.S. goods imports (from around the world) are currently threatened with tariffs, the majority come from China with Mexico also particularly targeted.
While the trade battle ebbs and flows, it is important to remember that the Chinese Administration owns over US$1 trillion of U.S. Government bonds. The Chinese may well be inclined to begin selling these bonds following the “controlled” depreciation of the Chinese Yuan against the USD. A falling Yuan increases the value of USD assets for the Chinese and the selling of U.S. bonds may be a potent warning shot to the US Administration.
Since April the Yuan has depreciated by over 8% against the USD without interference from the Chinese authorities. Importantly for Chinese exports to the US, this depreciation will partly offset the tariff impost for landed Chinese goods into the U.S. This is also important because inflation is stoking up in the U.S. as labour markets become tighter.
In June, China’s trade surplus against the U.S. increased to a record monthly surplus of USD29 billion. The depreciation of the Yuan is President Trump’s worst nightmare as it ensures that U.S. corporations will find it difficult to replace China as a source of supply for either goods or parts.
Another point of note, seemingly forgotten by Trump, is that the U.S. runs a significant “services” surplus with China. This surplus has been steadily expanding, as Chinese tourists and students head to the U.S., Chinese households watch more Hollywood movies, and China imports more U.S. software and other intellectual property. In any escalation, China could target these services imports, by restricting tour groups or reducing the number of American movies shown.
The lost benefits of trade, poor wages growth, the higher cost of living, surging corporate profit growth and growing inflationary pressures are seemingly now leaving many U.S. citizens to question their belief in the U.S. Whether they support or believe their President or not, there is a growing level of discomfort with life in the US – as measured by the declining numbers of citizens that are proud to be American.
Quote: “The anxiety of parents like me — educated professionals without many assets to show for it — animates Alissa Quart’s new book, “Squeezed,” a dispiriting survey of the economic stress felt by families who belong to the “Middle Precariat,” as Quart calls the new middle class. As her coinage suggests, this once large swath of the population is narrowing, its members finding their financial situation increasingly tenuous. Much that middle-class professionals took for granted in previous generations, including homeownership, decent health care, a comfortable retirement, is now out of reach. Over the past 20 years, the cost of housing has risen dramatically. The price of healthcare and college has almost doubled. Meanwhile, wages have stagnated, unions have nearly vanished and, in some sectors, technology has replaced human workers. Many people find themselves carrying school and credit-card debt, and working low-paid, temporary or part-time jobs. Those in certain industries, like tech or finance, are forced to work long hours as a matter of course; others supplement jobs that once upon a time would have been considered full time, such as teaching, with temporary gigs such as driving an Uber.”
Source. Cooke, E 2018,“In the Middle Class, and Barely Getting By”, The New York Times, July 9, https://www.nytimes.com/2018/07/09/books/review/alissa-quart-squeezed.html
The breakup across the categories of U.S. citizens are somewhat predictable and the disenchantment of young Americans is evident. Whether President Trump can corral these people to support him will be a major issue in the coming midterm elections in November and the Presidential race of 2020 – if indeed Trump decides to run again.
The trade battle with China and the repercussions for the US economy could well dictate Trump’s future. He is unlikely to face the younger electorate if they continue to come out in droves against him.
While many commentators are calling inflexion points in the Trump Presidency – that is the point where his Presidency becomes terminal – we suspect that he will limp forward throughout his term.
More important will be the market’s reaction to the growing trade tensions and risk that U.S. economic growth is substantially slowed by poor economic calls by the Trump administration.
At this point, markets are sanguine – bond yields are near historic lows and equity markets near all-time highs – leading to a view that markets are relaxed with the outlook and expect Trump to backflip once he has secured some form of concession from China. The risk is that he loses control of the negotiations and the support of the U.S. Congress and Senate. At that point, the U.S. political system will reach a true tipping point – the point at which it must take responsibility for an electoral system that has produced a strange and dangerous outcome. That point may be brought forward if the headwinds of 2019 become too powerful and that is why this trade dispute should not be discounted.
In the meantime, in testimony to the U.S. Senate Banking Committee yesterday, Federal Reserve chairman Jerome Powell discounted the risk that a trade war may throw a global recovery off track, and said the economy is on the cusp of “several years” where the job market will remain strong and inflation will stay around the Fed’s 2% target. Let’s hope he is right.