The deadline has passed for implementing the tariffs targeting $200 billion of Chinese exports to the US. There is no material change as of yet, but the war of words is heating up on both sides.
China Channeling Sun Tzu
Trump may have written the Art of the Deal, but Sun Tzu wrote the Art of War 25 centuries ago. Do not underestimate China. Not only did the deadline on the tariffs on $200 billion pass without implementation, but Trump also revealed his weak hand when Treasury Secretary Mnuchin was dispatched to restart talks with the Chinese. Trump’s impulsive nature got the best of him this time, and his administration is now considering revisions and new tariff targets less likely to produce a backlash from his constituents.
Having sensed weakness in Trump’s position, the Chinese took no time to decline the Trump Administration’s offer to restart negotiations. According to the Wall Street Journal, the Chinese are refusing to talk after Trump tweeted yet another threat. The Chinese have plenty of dry powder if this trade war escalates any further. We are now assessing a higher probability that the USD/CNH will break higher, especially if the Chinese are truly done talking.
Despite the US-Chinese trade war, we continue to believe markets have overly discounted Chinese equities. We do not see the same discount in US companies that depend on trade with China, and that makes Chinese equities relatively cheap. We are entering a new phase of uncertainty that is sure to present many buying opportunities in China and elsewhere in Asia.
Interest Rates and Inflation Rising
The Bank of Russia surprised us last week when it hiked rates by 25 basis points to 7.5%. Turkey was expected to hike by most market participants, and Erdogan’s reaction was predictable: In reference to the central bank’s misalignment with his policies, he said, “We will see the results of the independence,” and again he threatened that his patience with the central bank has limits. The Turkish central bank hiked the one-week repo rate by 625 basis points to 24%. This happened a day after Erdogan decreed that all contracts between Turkish entities can only be denominated in Turkish lira.
These hikes are just the beginning because Emerging Market central banks will have a higher hurdle to overcome when rates on the dollar rise further from these levels. We expect to see the Fed Funds Rate rising in September, which will make the dollar funding trade more painful. An escalation of the trade war will not help because import price inflation will be felt more immediately than the effect of the drag on aggregate demand.
The Dollar Shortage
We have touched on this subject briefly in past articles. The rest of the world is short dollars in aggregate because of dollar-denominated credit expansion outside of the US. One way to understand this is to look at the aggregate balance sheets of the financial and non-financial sectors outside of the US. In accounting, there is always a double-entry that balances the balance sheet on “assets” side and the “liabilities + equities” side. For every US dollar liability, there is a US dollar asset.
It is reasonable to assume that the financial sector has relatively small FX mismatching on aggregate because these open positions consume regulatory capital, as per globally-mandated BASEL rules. What remains in the non-financial sector is measured by BIS statistics. As of Q1 2018, there is an aggregate liability position of $11.48 trillion denominated in USD, owed by non-bank entities outside of the US. Total foreign exchange reserves denominated in USD are estimated to be $6.5 trillion as of Q1 2018. So here is the dilemma: where will the rest of the world find the necessary dollars to repay its net dollar liabilities to the US?
The answer contradicts everything Trump has been saying. The global economic system evolved to export goods to the US consumer to earn US dollars to pay US dollar liabilities. The trend that saw globalization rise to its current levels started with the Marshall Plan. The US began to actively encourage the outflow of dollars to the rest of the world to allow for the repayment of debts to the US accumulated after World War II.
This trend never really reversed, the US dollar became the international reserve currency, and the Marshall Plan debt became the private-sector debt owed to US multinationals. Today, the US would run a trade deficit by importing iPads and iPhones from China because of a US multinational funding investments in China with US dollars. Is it any surprise that companies like Apple are warning Americans that it will have to raise prices if the tariffs on China are implemented?
The Week Ahead
Markets are awaiting apprehensively for Trump’s reaction to China’s snub. Chinese equities will re-test the lows, and the reaction out of Europe is unlikely to be positive. No change is expected when the Swiss National Bank announces its rate decision on Wednesday. On Monday, Turkey is expected to announce its government budget balance.
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