US-China trade war: walking a tightrope

• Recent escalation: Donald Trump proposed additional 10% tariffs on a further US$300 billion worth of Chinese imports from 1 September. This is surprising, given that the two countries appeared to have found some common ground at the G20 meeting in June. However, the truce was short-lived and China responded with its own set of measures inform of a suspension of US agricultural imports and currency devaluation, which could further escalate the situation.
• Economic implications: Global trade will remain under pressure. There is no reason to expect a recession, but the impact on growth will be sufficient to change economic policies, starting with monetary easing. Most central banks in emerging countries are also in an easing mode. The risk now is that the trade war will turn into a currency war. The trade war will redesign the map of global value chains and some economies may therefore be able to benefit from new foreign direct investments.
• Investment implications on emerging markets (EM): A long term trade war could reduce global growth, caused by a slowdown in China and the US. However, this trade war could very well be a fight for global supremacy between the two leading economies. Some emerging countries more focused on domestic demand and restructuring of global supply chains may be better able to navigate the volatility, whereas others that are well integrated in the present technology chains would suffer the most. Investors should stay clear of any extreme positions and adopt a more defensive approach. On EM debt in hard currency we believe that liquidity by central banks will continue to be supportive, while we are more cautious on EM currencies, especially in Asia.
• Investment implications on asset allocation: The US formally designated China as a currency manipulator but it is not clear what specific actions the two sides would take. However, what’s clear is that investors would not like the uncertainty and the impact it has on business decisions. We are in a late cycle phase and believe that a cautious approach is recommended through a positive stance on US treasuries (although somewhat reduced after the strong rally) and a cautious view on equity. We think that this phase of volatility may open selective opportunities in equities across the emerging and developed market spectrums. Investors could also look at gold to mitigate volatility. All in all, we prefer defensive themes in light of the current market backdrop.

Do you believe that the recent escalation on the trade war represents a turning point and what are the implications (of the additional tariffs) on global trade, the Chinese economy and global economic growth?

The truce in the US-China trade war announced in late June at the G20 meeting has proved short-lived. Donald Trump decided to “dig up the hatchet”. It has become increasingly difficult to distinguish between simple announcement effects (aimed above all at pleasing his electoral base) and a more fundamental strategy of confrontation with China. Although it is possible that the American and Chinese authorities will eventually find a common ground, recent events clearly do not pave the way for an agreement anytime soon. Continued tensions between the US and China are inevitable, at least in the short run.

It will now be difficult for Donald Trump to calm things down. Even in case of a subsequent deescalation, the damage is done. Global trade will remain under pressure due to uncertainty caused by trade tensions that have become recurrent and unpredictable. Macroeconomic simulations released by the OECD in the spring showed that this could cost a few tenths of a percentage point growth in advanced economies. Tensions are also disrupting global value chains and weighing on business investment, in particular in the trade-sensitive countries in both the developed and the emerging world. As a result, the manufacturing sector may weaken further. In the Eurozone, it is clearly the German economy that is the most sensitive. However, the Eurozone as a whole — that is twice as open as the US economy — would naturally not escape unscathed. Ultimately, growth might well fall below its potential level next year in the US, Europe and Japan simultaneously.

Do you think a recession is more likely now and would you expect the Fed to fasten the pace of rate-cuts to counter the negative impact of the trade war on the US economy?

At this stage, there is no reason to expect a recession, but the impact on growth will be sufficient to change economic policies starting with monetary easing. The Fed would probably continue to lower rates. In fact, markets are already anticipating a decline of more than 100bp within the next 12 months, although we believe it is excessive. For the time being, the services and the consumer sectors are showing resilience. The more accommodative monetary conditions should continue to support domestic demand and the latter should also offset, at least in part, the negative impact of global trade on GDP growth. Moreover, fiscal policies will become even more supportive if growth is really threatened.

The impact on Treasury yields results from a traditional flight to quality when risk aversion rises. The decline in US long-term rates is all the less surprising because equity markets had already performed very well since the beginning of the year and the Fed has started to lower its key rates. Secondly, there is a shortage of liquid and safe assets worldwide and US Treasuries are almost the only ones to offer clearly positive returns in high rated developed countries. It is interesting to note that bond yields of all maturities have fallen (the spread between the 10-year and 2-year yields remains positive).