By Kevin Muir
It was about a month ago that President Trump first warned us. Having finally figured out he had considerable power to affect trade policy, Trump went on the offensive.
As I always promise, I will leave politics aside and refrain from making a judgment about whether his policy is in the best interest of the United States or the world in general. No sense arguing about the merit of Trump’s decisions, they are what they are. I would rather examine what this policy might mean for markets going forward. But before we do that, it’s helpful to remember how we got here today.
It’s easy to forget that not too long ago China’s economy barely registered on the global stage. In 1995, China’s GDP made up less than 2% of the world economy.
China was in the midst of a monumental reform that would transform their economy from an agriculturally-based rural third-world nation into a dynamic increasingly urban-based manufacturing powerhouse.
But their first step was to devalue their currency.
In a series of moves that culminated with the final markdown in January of 1994, the Chinese devalued their currency by over 80% in a little more than one decade.
In doing so, the Chinese artificially undercut the entire world by keeping their currency at depressed levels. Capital flooded into China as global manufacturers rushed to take advantage of the cheap labour and the even cheaper currency.
As capital entered, the Chinese government faced a problem. The demand for Yuan caused upward pressure on the currency. If the government allowed the currency to rise, it might negate the economic reforms the leadership was trying to accomplish. Desperate to maintain the cheap currency, the Chinese government maintained the peg by selling (creating) Yuan and buying US dollars (and other currencies, but since the US dollar is the reserve currency, it ended up being largely US dollars).
China’s foreign exchange reserves grew at a fierce rate. From almost zero in 2001 when China entered the WTO, their fx reserves rose to $4 trillion in 2013.
This massive growth has had tremendous implications for the global financial system. As the Chinese government sold more Yuan and bought U.S. dollars, they reinvested the USD back into US Treasuries and other relatively safe fixed-income vehicles. This had the effect of pushing interest rates lower, which when combined with the falling rate of inflation from the cheap Chinese goods that were entering America, sent bond prices rocketing higher. As interest rates fell, many consumers were able to refinance their mortgages (or take out equity home lines of credit), which allowed them to buy even more Chinese goods. This, in turn, caused the Chinese government to have to sell even more Yuan and again buy USD, thus creating a self-reinforcing feed back loop.
To some extent, the credit excesses that led to the 2008 Great Financial Crisis were the direct result of the Chinese economic reform. China’s transformation had the effect of creating lower inflation and lower interest rates in the rest of the developed world.
I know this is a simple explanation of a much more complex interaction between China and the rest of the world. Yet, at its heart, this is what happened from China’s economic rise.
So, if we assume that Trump wants to reverse this process, then what’s the logical outcome?
I would argue that it will result in higher inflation and higher interest rates. Especially if the Federal Reserve chooses to monetize any slowdown that would be the result in the trade tariffs.
An earlier tweet by Arun Chopra from Fusion Point Capital seemed especially spot on:
Trump is attempting to unwind 30 years of Chinese mercantilism in a month long twitter feud. I would agree that given the stretched nature of the equity markets, there is a lot of risk that it might develop into a full-on trade war.
Yet, I wouldn’t be so quick to think that the US stock market will be the biggest loser from such a development. As long as Central Banks are willing to monetize the slowdown, the real danger will be how long-term bonds react.
And as usual, I see little reason to believe the Central Banks won’t be there with the printing press ready to run. In fact, the ECB’s second in command has already hinted at delaying tapering due to the escalating trade dispute. From a Bloomberg article:
Protectionist sentiment has already “contributed to tighter financial conditions,” Coeure said on Friday at the Ambrosetti Forum in Cernobbio, Italy. “A ‘trade war’ scenario would add to global uncertainty at a time when some central banks have only just begun the process of unwinding the unconventional policy measures put in place following the global financial crisis.”
The ECB, which is currently considering when to halt its bond-buying program, has repeatedly warned that any unwarranted tightening of markets could delay its exit from stimulus.
Inflationary protectionist trade policies combined with accommodative Central Bankers seems like a long-term bond investor’s worst nightmare. Time to add to the steepeners?
Have a great weekend,
PS: Alternatively the Trump administration could just ask for the free floating of the Chinese Yuan. It’s strange that this demand has been completely abandoned. I wonder if we are going to hear more about this option in coming weeks.