The Outlook: June 2019 economic commentary

Commentary

Stakes raised in the US-China trade conflict.

What happens in China, matters for investors. It is the world’s second largest economy, accounting for around 20% of global GDP, and has had an increasingly important influence on the global economic cycle in recent years. Unsurprisingly, therefore, adverse developments regarding both the strength of the Chinese economy and the state of US-China relations have unsettled financial markets in recent weeks.

Take US-China relations first. The run-up in global equity markets during the first four months of 2019 had, in part, been based on the assumption that the US and China would agree a trade deal by the summer. Progress in ongoing trade talks was expected to halt the sequence of tit-for-tat tariffs that President Donald Trump had initiated in the spring of 2018. However, this optimism was shattered when negotiations broke down at the beginning of May, amidst US accusations that the Chinese had reneged on several aspects of the draft trade deal.

Trade war escalates

As a result, the trade war has escalated. On 10 May, the US authorities raised the tariff on US $200 billion worth of Chinese imports from 10% to 25%, and on 1 June China retaliated by increasing tariff rates on US $60 billion worth of imports from the US. In addition, President Trump has threatened to impose a 25% on the remaining US $300 billion worth of Chinese imports if an agreement between the two countries is not secured at the forthcoming G20 summit in Japan on 28-29 June.

Moreover, it is becoming clear that the conflict is now moving beyond the mere exchange of tariffs and is morphing into a broader economic and technology war. In mid-May, the US Department of Commerce banned the Chinese telecoms giant Huawei from doing business with American companies without special approval due to security concerns. In response, Beijing has announced several counter-measures, including drawing up its own list of foreign entities it deems as harming Chinese companies. In a bid to undermine the US tourism sector, which benefitted from nearly three million Chinese visitors in 2018, Beijing has issued travel warnings to Chinese residents thinking of vacationing in the US. There has also been talk of Chinese consumers boycotting American goods.

In addition, China’s National Development and Reform Commission is considering proposals to restrict exports of so-called rare-earth minerals. Such minerals are key inputs in the production of high-tech goods such as smartphones, electric vehicles and military equipment. Given that China accounts for about 80% of all rare-earth materials supplied to the US, such a move could produce significant disruption.

Chinese economy slows

The souring of US-China relations has come at a time when Chinese economic data has also taken a turn for the worse. During the first quarter of the year, hopes were high that the economy was stabilising, following the marked deceleration witnessed in 2018. China’s GDP grew 6.4% year-on-year in Q1, the same pace as that seen in the final quarter of 2018. However, recent data has cast doubt on the view that Beijing’s domestic stimulus measures were offsetting the negative impact of the trade conflict. Figures for May showed growth in industrial output slowing to 5.0% year-on-year – a 17-year low – as output of automobiles and computer equipment saw sharp slowdowns.

The latest round of protectionist measures from the Trump administration threaten to make matters worse. Huawei announced on 17 June that the US blacklisting of the company had contributed to a 40% month-on-month fall in sales of its handsets in May and had forced it to revise down sales forecasts by around US $30 billion. Huawei’s annual revenues are now expected to be flat at around US $100 billion this year and next.

The downbeat mood at Huawei chimes with a broad deterioration in confidence amongst Chinese manufacturers. The latest Markit manufacturing PMI survey showed sentiment regarding future output dropping to its lowest level since the gauge began in April 2012. Although data from the services and retail sectors has been somewhat firmer, there is a risk that job losses in manufacturing will take their toll on household sentiment. The official NBS manufacturing survey for May showed the employment sub-index falling to a 10-year low. With household incomes squeezed by the rising cost of living, as the recent outbreak of swine flu and adverse weather combine to push up food prices, discretionary expenditure could be hit. 

In terms of the impact on GDP of increased tariffs, most forecasters conclude that the direct hit to China will be worse than that to the US. The OECD reckons that under a scenario where tariffs are imposed on all US-China trade, US GDP would be around 0.8% lower by 2021-22, while Chinese GDP would be more than 1.1% lower. This said, gauging the impact of higher tariffs is problematic, given the difficulty in estimating ‘second round’ effects on business/consumer confidence, as well as possible ramifications in financial markets.

Policy stimulus

One advantage that President Xi does have over President Trump is the capacity to swiftly enact policy stimulus to counter the negative effects of the trade dispute. The independent US central bank - the Federal Reserve - has so far ignored President Trump’s repeated calls for monetary policy to be loosened, and any fiscal stimulus in the US would need to be approved by Congress. In contrast, China has recently introduced a raft of measures to boost domestic demand. These include tax cuts, the easing of restrictions on local government funding of infrastructure projects, incentives to boost spending on consumer goods, and an accelerated upgrade of the country’s telecommunications network.

Given that the authorities will not want celebrations of the 70th anniversary of Communist party rule in October to be tarnished by a weak economy, further stimulus is likely to be forthcoming. The Governor of the People’s Bank of China (PBOC), Yi Gang, recently declared that he had ‘tremendous room’ to adjust policy to support the slowing economy. With the PBOC’s benchmark interest rate at 4.35%, there is clearly scope for both rate cuts and reductions in the reserve requirement ratio, which would facilitate an increase in bank lending.

However, aggressive monetary easing would not be without risks, and would mark a clear reversal of earlier attempts to make economic growth less dependent on debt and more sustainable. Looser monetary policy would risk fuelling bubbles in asset markets. It could also put downward pressure on the renminbi. In turn, this could unnerve global financial markets, with investors mindful of the volatility triggered by the depreciation of the Chinese currency in 2015.

Given that Beijing has both the capacity and willingness to mitigate the downside risks of the trade war, expectations that President Xi will be bullied in to making big concessions to US negotiators are likely to prove misplaced. If, following the G20 meeting, President Trump carries out his threat to impose 25% tariffs on the remaining US $300 billion of Chinese imports, renewed financial market volatility is likely. However, with recession risks rising in the US and the presidential election looming in 2020, President Trump has a clear incentive to engineer a face-saving climbdown.

In the short-term, an agreement to resume talks and a postponement of new tariffs is probably the best outcome investors can hope for. Over the longer-term, the ongoing competition between the US and China for economic and technological dominance will be a key factor shaping investment portfolio decisions for years to come.

This article is for generic information only and is not suggesting a suitable investment strategy for you. You should seek independent financial advice that takes your individual circumstances into account prior to proceeding with any course of action.

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