Thursday, April 5th, 2018
Thirteen months of relative stability in the US stockmarket have now given way to eight weeks of increasing volatility and uncertainty. The inflection point (late January) was passed with the fear of emerging inflation, as US wages were observed to be rising above trend. More recently, the trade policy settings of President Trump have exposed a steady world growth position and outlook to an unexpected jolt. This has occurred at a time when Trump’s grip on the Presidency is seemingly as precarious as the position of the Australian cricket team and its captain.
Figure 1. World Trade Volume and World Industrial Production, Jan 2000 – Dec 2017
Source. CPB Netherlands Bureau for Economic Analysis
The Trump trade policy is both deliberately and excessively US-centric. At its core is the attempt to rectify historic US trade imbalances. This imbalance has flowed following decades of reducing trade barriers, which in turn have driven world growth and the emergence of the Asian economic bloc led by China. An important result of this open trade engagement by the “developed world” with the “emerging world” has been the dampening effect on inflation. Open trade has generally resulted in the retail prices of manufactured goods (eg, computers, electronics, TVs, furniture, toys, shoes and clothing, etc … but excluding new products or inventions) declining for the last twenty years.
The manufacturing bases of emerging economies (think cheap labour) have been strategically utilised by large US and European multinationals to lower their manufacturing costs. The benefits of lower costs of consumable goods generated from open trade, while of great benefit to business profitability, are lost across the broader society as many other service charges have risen. Hence the extreme frustration with political leaders generally, the rise of populism in Europe (eg, Brexit and most recently in Italy), and the emergence of Trump in the US. Skilled manufacturing jobs have been lost and replaced by a range of services jobs whose pay scales range from low (flipping burgers at MacDonalds) to excessively high (CEOs and the upper echelons of professional management). Unfortunately, the excessively high are relatively few and generally related to low-output professions like financiers, sportspeople and lawyers.
It is our view that politicians and the western intelligentsia have championed free trade without having any idea of what it really means for the average middle class citizen, or how its benefits can or should be fairly dispersed across society. In response to free or open trade opportunities, countries must garner the benefits of the lower cost of imported goods and develop efficient export industries in response. This often shows up in the growth of sectors benefiting from comparative advantage. Today, Australia is witnessing growth in tourism and education, but the benefits are frittered away when excessive leverage and credit lifts the cost of living elsewhere (eg, higher mortgages or rents).
Trade is clearly the engine propelling the lift in living standards for the lower income classes living throughout Asia. Since 1978 perhaps 300 or 400 million Chinese have risen from poverty to middle class, with China’s GDP growing at roughly 10% per annum, and the average Chinese person’s income quadrupling. Trade also has the potential to lift the living standards of the middle classes of the western world, but over the past few decades the opportunity has been waylaid by poor political and economic leadership and excessive self-interest displayed by large financial institutions and multinationals.
The chart below shows that world trade was growing rapidly prior to the GFC, propelled both by IT advancements and a western world consumer debt binge. This growth slowed noticeably as the developed world meandered through economic recovery.
Figure 2. World trade in volume terms
Source. CPB; Natixis AM; phillipewaechter.en.nam.natixis.com
Since 2008, world economic production has lifted by over 20% with the bulk of this growth achieved through the developing world and notably China. The developed world, through free trade agreements and engagement, led by vast multinationals, directed that manufactured goods could be better and more cheaply produced in the developing world. The twentieth century’s industrial leaders Japan, Europe and the US have flounded since 1990 and this decline has accelerated since the GFC.
Figure 3. Industrial Production Indices since 2008
Source. CPB, Datastream; Natixis AM; phillipewaechter.en.nam.natixis.com
In nominal GDP terms, China’s production will surpass that of the European Union in 2018. The EU has barely grown since the GFC while China’s output has grown 200% – benefiting from both positive trade winds and rising consumerism in China itself. Comparative advantage, free trade and capital mobility have been well managed by the Chinese communist party leadership to its advantage, while there has been no co-ordinated counter or well thought-out strategic response in the developed world. That was until Donald Trump arrived – but the measure and wisdom of his thought process is yet to be proven. Maybe we could ask Stormy Daniels what she thinks!
Figure 4. Nominal GDP Levels, 2017 & 2018 – China & Euro Area
Source. Bloomberg, World Bank, International Monetary Fund
The trade tariffs proposed by Trump come at a time of synchronised world economic and manufacturing growth. The following table presents the Purchasing Managers Index (PMI) for the world economy. The PMI is an effective indicator of the economic health of an economy’s maufacturing sector. It tracks five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment. It is notable that over the last two years, PMIs have recovered strongly in the developed world. This is a relative measure of growth that is now occurring after a period of sporadic performance.
Figure 5. Global manufacturing PMIs
Source. Thomson Reuters Datastream
Actual growth rates are more clearly shown in the next table which tracks year on year growth. Advanced economies suffered falls in industrial production over 2015 and 2016 while emerging economies powered on. The recovery in developed economy industrial production has come after a significant dip which should be acknowledged when assessing the current world trade position.
Figure 6. Global industrial production
Source. CPB, Thomson Reuters Datastream
World trade and the US position
The next two charts explain why markets are concerned by Trump’s proposed tariff policy. It comes at a time when both export and income growth has surged across the developed world economies. 2017 ended on a strong note and the fear is that Trump’s actions could destabilise this.
Figure 7. Export volume growth, % yoy, 12 months’ moving average
Source. CPB, Thomson Reuters Datastream
Noteworthy is the surge in Japan’s export growth, exceeding the growth in their imports (noted below). In Europe, growth in exports has also exceeded import growth but in the US the story is clearly different. Both exports and imports have lifted by the same degree and a relatively weak USD from late 2016 has not helped rebalance the US trade account.
Figure 8. Import volume growth, % yoy, 12 months’ moving average
Source. CPB, Thomson Reuters Datastream
The trade deficit in the US deteriorated as the country recovered from the GFC and employment levels headed towards full employment (unemployment now at 4.1% and likely to fall even lower). The chart below presents the US merchandise trade deficit which produced a shocking result in January ($74.3 billion deficit). The annual result now exceeds $500 billion and about 50% of this deficit is represented by trade with China.
Figure 9. US merchandise trade deficit
Source. Census Bureau
While much has been said regarding Trump’s targeting of China, the next chart shows that Europe also runs a surplus with the US. Clearly the trade mismatch with China (3 times more imports than exports) is great, but American trade deficits with Germany, France and Italy have also caught Trump’s attention.
Figure 10. US trading activity by region/country (2017)
Source. Census data, US Equity & Quant Strategy
US trade deficits exist across a wide range of merchandised products. With China, the biggest US imports are noted in computers, mobile telephones, knitwear, footwear and toys. But while the US is a major buyer of these goods, China has many other trade partners. The chart below shows that China has diversified its trade partners and products so that the US has diminished in relative importance. Would a trade war hurt the US more, or would it hurt China more? Targeting China alone does not resolve the trade deficit, and so a trade war with virtually the whole world would be needed. Somehow, it seems distinctly possible that Trump may be severely miscalculating.
Figure 11. US-China trade war
Source. International Trade Centre
The real underlying concerns of a trade war
Our final three charts put into context the risks from a trade war erupting. While it is clear that economic growth could falter, it is the secondary effects on corporate profitability and the cost of debt that are of heightened concern.
The export sector (non-US earnings) of the US S&P 500 companies is dominated by technology companies. The table below shows that US technology companies have greater exposure to offshore markets than they have from their domestic market. We also note that the US energy sector has been rapidly replacing imports and it will soon have a majority of earnings emanating from exports as America becomes self-sufficient in energy. Trump’s plan includes the imposition of 25% tariffs on $60 billion of (as yet unspecified) Chinese exports to the US. The optimistic view is that this is simply the opening gambit in a negotiation that will end in a deal. The pessimistic view is full blown trade war with unknown long term consequences following cycles of retaliation.
Figure 12. S&P 500 companies’ foreign exposure by sector
Source. FactSet, US Equity & Quant Strategy
US multinationals would have a lot to lose if reciprocal tariffs are placed on their exports or if US corporates are targeted for higher taxes on non-US profits.
The next chart shows that world stock markets, driven by the US equity market, have accelerated upwards. The acceleration in market prices was extraordinary over 2016 and 2017 with no corrections until January this year. Arguably, prices were supported by a view that nothing could go wrong. Volatility slipped to historic lows and the market looked forward to Trump continuing to support the corporate sector through tax cuts and pump priming the US economy with fiscal deficits.
Figure 13. World Stock Market Capitalisation, Jan 1992 to Jan 2018
Source. World Federation of Exchanges
In late January, the US market hit its highest value relative to US GDP in history. The market valuation stretched to 150% of GDP, and the 10% market correction that has followed has certainly pulled the market back from dangerous highs. (One should note that US market valuation relative to global GDP is below previous highs, which is relevant based on the global nature of many of the US’s largest companies.) However, a trade war would certainly have free capital questioning whether the current valuation of 135% of GDP is justifiable.
Figure 14. US Market Capitalisation of Stocks as % of GDP
Finally, there should be a measure of caution in Australian financial markets. While we have seemingly escaped the first tranche of Trump tariffs and quotas (steel and aluminium), we will become collateral damage from a trade-induced downturn from China, Asia and Europe. Indeed, Martin Wolf of the FT notes that if the Chinese were pressured into reducing their trade deficit with the US, one tactic employed could be to for China to replace non-US imports with US imports.
“China could import liquefied natural gas from the US. This would reduce the bilateral surplus, while merely reallocating gas supplies across the world. But doing the same thing for commodities in which China is the world’s dominant market would be far more problematic, since it would hurt other suppliers. Mr Trump may well want China to discriminate against Australian foodstuffs or European aircraft. That way lies the end of the liberal global trading system.” – Martin Wolf, FT
Free trade has helped hold down inflation and support lower interest rates. A reversal in free trade and inflation will naturally lead to higher interest rates.
An omnipresent issue for Australia is the funding of our major banks’ balance sheets. Our final chart shows that our banks are holding their funding from wholesale offshore markets at similar levels seen before the GFC. Meanwhile, the Australian household sector continues to increase its debt and their reliance on mortgages to purchase houses.
Australia would not escape the effects of higher interest rates that could follow an upheaval in the world economy resulting from a trade war. In recent weeks, the international interbank wholesale market has seen a sharp lift in interest rates. This will flow through to Australian banks, which will then pass it through to mortgage borrowers. Already we have seen Suncorp lift its home loan fixed rate.
Figure 15. Foreign lending to Australian banks
Source. Bloomberg, Thomson Reuters Datastrea, Credit Suisse estimates
While there is much speculation that Trump is grandstanding on trade and will walk back his most egregious proposals for concessions, there seems little doubt that on any scenario, the downward pressure on inflation from open free trade has passed the tipping point. The equity, debt and bond markets will be watching Trump’s trade policies with wary eyes and real concern. Volatility has thus become an unwelcome feature of 2018.
Source. Financial Times