Tuesday, July 2nd, 2019
At this point, markets seem relatively relaxed as they regard it as quite likely that US-China trade talks will get back on track, whilst doubting that a deal can, in fact, be struck before the end of the year.
This view is based on observing Trump’s political calculus as he gears up for his re-election campaign in 2020. It is clearly to his political advantage to restart the talks, and just as clearly not to his advantage to come to a deal too soon. Moreover, the substantive gulf between the two sides that was revealed by the early-May collapse of negotiations is too large to be easily bridged.
It seems to us, that barring a major Trump faux pas, he will keep China “in play” by not committing to a firm course of action one way or another. The talks will restart, Trump will put aside the threatened 25% tariff on the US$325bn of so-far un-tariffed Chinese imports, but he will not rush to get a deal done.
While it is unclear how any deal would be an acceptable agreement for President Trump, given he seeks an “enforceable” and massive drop in the projected trade deficit, we note some statements from the Chinese as to what is acceptable to them. These are:
(i) the trade deficit-reducing list of Chinese purchases of US goods must be “reasonable” (i.e. smaller than demanded by the US team);
(ii) immediate tariff reduction must occur; and
(iii) the text of the agreement must “respect Chinese dignity.”
The US requires any deal to include stringent enforcement provisions that make it hard for China to wriggle out of meeting its commitments and impose harsh penalties if it does not do so.
The prevailing narrative in the US is that China cheats on its agreements, so they would like most of the tariffs to stay in place, be reduced only gradually (if at all) in response to China actually delivering on its commitments, and be automatically re-imposed—with China waiving its right to retaliate—if the US unilaterally finds that China has backtracked.
Conversely, the narrative in China is that “the US is a bully trying to impose an unequal treaty in the manner of the 19th-century colonial powers, and that the American demand to act as judge, jury and executioner is an intolerable infringement of Chinese sovereignty”.
Thus, there is no pathway to a quick resolution, and this will suit Trump. However, if the US economy and markets are shaky, he will have an incentive to cut a deal and hope that the resulting boost to equity prices will shore up his electoral prospects. Either way, this is a call better made in a year’s time.
China and bond yields
Since the turn of the century, China has amassed over US$3 trillion in foreign reserves through a succession of current account surpluses.
As observed in the chart below, the bulk of this has come from the trade account surplus for goods that predominantly flows from trade with the US.
However, we see a growing reverse trade flow in services as tourism grows rapidly. The Chinese are travelling at an increasing rate and this is bringing the current account back towards balance. Thus, the US President should be careful to protect this burgeoning income flow, much of which is flowing to the US – but we doubt that he will.
China also pays international creditors interest on its growing holdings of Chinese bonds and debt. The chart above shows the growing net interest payments made by China. The world is partly funding China’s growth and is happy to do so given the historically low bond rates on offer across the developed world.
China’s gross holdings of international assets and net foreign reserves are shown below. Notably, China has focused outbound investment in direct investments and has not been active in equity or corporate debt markets. In terms of foreign reserve assets, the Chinese Administration has accumulated significant bond holdings (e.g. $1.2 trillion of US bonds) but has eased purchases more recently and, according to figures released by the People Bank of China, they seem to be accumulating gold as part of their reserve management.
The reason as to why China is not accumulating bonds is seen below. A scan of major economy bond yields shows this:
|US 10 year||2.02%||20 year 2.52%|
|Japan 10 year||-0.14%||20 year 0.23%|
|Germany 10 year||-0.31%||30 year 0.27%|
|France 10 year||0.03%||30 year 0.96%|
|United Kingdom 10 year||0.82%||20 year 1.31%|
|Australia 10 year||1.29%||20 year 1.71%||30 year 1.91%|
|China 10 year||3.27%||20 year 3.60%||30 year 3.88%|
|India 10 year||6.85%||30 year 7.05%|
The observation we can make from the data, is that bond yields are significantly compressing along the yield curve.
The unrelenting use of QE appears designed by the European and Japanese Central Banks to potentially buy virtually all Government bonds on issue. The normal or natural owners of government bonds are banks, insurance companies and pension funds. These entities require the yield on bonds to meet the liabilities they have. However, yields have been compressed by Central Banks competing for these bonds with the natural market buyers.
The yields on bonds as a result of QE have recently been targeted by President Trump as evidence of manipulation by both Japan and Europe, designed to support their economies through trade. He claims lower interest rates depress their currencies to create unfair trade benefits. This is probably true. It will be interesting to observe whether this claim is made openly at the G20 meeting.
In 2018, it was observed that Russia sold the bulk of its US bond holdings and diverted the proceeds into gold. In recent weeks, the gold price has galloped higher as more bonds fell into negative yield territory.
The graph below shows an observable correlation between the amount of negative yielding bonds (which now exceeds US$12 trillion) and the price of an ounce of gold.
While the value of gold is impossible to derive in any objective or fundamental sense, it seems that the speculative forces behind its price are being fueled by the combination of negative real or actual bond yields, the elevated level of the USD and potential currency wars, trade dislocation and the heightened Middle East geopolitical tensions emanating from Iran.
Gold has historically been driven by inflation surges or as a hedge against extreme uncertainty. But today, who could argue that a negative yielding German ten-year bond is a better investment than gold?
While logic tells a value-based investor that gold is grossly inferior to equities, property or corporate debt (primarily because it has no earnings and offers no yield), it is the debasement of bonds as a sustainable part of a diversified portfolio that opens up the argument for gold – and particularly for speculators or for the support of foreign reserves held by emerging economies.
Investment professionals over the decades have advised people to stay away from what John Maynard Keynes described as a “barbarous relic”. Money put in gold does little for the economy; since it has no productive value, it is seen as a dead weight. And yet for thousands of years, people in most parts of the world have bought gold as a store of value. Even central banks are buying more of the precious metal.
Governments like China and Russia have another incentive besides negative yielding bonds to buy gold. Given continued tensions with the US, both China and Russia are trying to weaken the link between the US dollar and their respective currencies.
Central banks are steady buyers…
China’s holding a tiny proportion of its foreign reserves…
Source: World Gold Council
Although Central banks continue to accumulate gold to diversify their foreign exchange reserves and reduce their exposure to developments in the US amid tensions, USD remains the dominant reserve currency.
Chinese imports creeping up