Thoughts on US-China Relations and the Investment Implications

The US Treasury named China as a currency manipulator, raising trade tensions further. A trade deal this year is now highly unlikely, and an extended trade war raises US recession risks. Still, we remain positive on the dollar and very negative on EM.

RECENT DEVELOPMENTS

China was named a currency manipulator yesterday by the US Treasury, despite being cleared in the most recent semiannual judgment back in May.  China was kept on the watchlist back then, but we believe an intra-report designation of manipulation is unprecedented.

Treasury must now engage with the IMF to determine what steps will be taken next. If there is no progress within a year, China would face possible sanctions such as Chinese firms being barred from competing for US government contracts. The potential penalties are quite limited when viewed against the tariffs and other restrictions already taken against China.  However, the symbolic move pours gasoline on an already raging conflagration.

Press reports suggest that President Trump made the choice to name China, leaving it to his staff to complete his directive. Treasury did so officially by citing the Omnibus Trade and Competitiveness Act of 1988. This unilateral decision apparently supersedes the criteria set forth in section 701 of the Trade Facilitation and Trade Enforcement Act of 2015 (see A Brief History Lesson below). As the table below shows, China only meets one of the three criteria needed to be named a manipulator.

Still, markets have calmed after the PBOC took steps to stabilize the yuan. The yuan was fixed at a level stronger today than what was expected. The bank also announced it will sell yuan-denominated bonds in Hong Kong, a move which would mop up liquidity and support offshore CNH. To us, this is a clear signal that China is not “weaponizing” their currency.   Rather, policymakers are taking steps to prevent excessive yuan weakness whilst allowing for a somewhat greater degree of market influence.

 

 

A BRIEF HISTORY LESSON

The Treasury FX report to Congress was mandated by the “Omnibus Trade and Competitiveness Act of 1988.” This legislation originally stemmed from an amendment proposed by Representative Dick Gephardt that would require the US to examine the policies of countries that had large trade surpluses with the US. To put it bluntly, the legislation was a response to the deteriorating trade position of the US. Many politicians blamed foreign trade barriers rather than domestic factors for this deterioration.

The initial report to Congress on “International Economic and Exchange Rates Policy” was meant to fulfill the process set forth in the legislation. Under Section 3004 of that act, “The Secretary of the Treasury shall analyze on an annual basis the exchange rate polices of foreign countries, in consultation with the IMF, and consider whether countries manipulate the rate of exchange…..for purposes of preventing effective balance of payments adjustment or gaining unfair competitive advantage in international trade.”

At that time, Treasury examined five areas of concern to decide if a country was guilty of currency manipulation: 1) external balances, 2) exchange restrictions and capital controls, 3) exchange rate movements, 4) changes in international reserves, and 5) macroeconomic trends.

The Treasury report was later amended by section 701 of the Trade Facilitation and Trade Enforcement Act of 2015. “The 2015 Act requires that Treasury undertake an enhanced analysis of exchange rates and externally‐oriented policies for each major trading partner that has: (1) a significant bilateral trade surplus with the United States, (2) a material current account surplus, and (3) engaged in persistent one‐sided intervention in the foreign exchange market.” Treasury noted that “Because the standards and criteria in the 1988 Act and the 2015 Act are distinct, it is possible that an economy could be found to meet the standards identified in one of the Acts without being found to have met the standards identified in the other.”

In the April 2016 report on “Foreign Exchange Policies of Major Trading Partners of the United States,” Treasury laid out the specific thresholds for the three new criteria regarding currency manipulation: “(1) a significant bilateral trade surplus with the United States is one that is at least $20 bln; (2) a material current account surplus is one that is at least 3% of gross domestic product (GDP); and (3) persistent, one-sided intervention occurs when net purchases of foreign currency are conducted repeatedly and total at least 2% of an economy’s GDP over a 12-month period.”

No trading partner was found to satisfy all three criteria in that April 2016 report and so none were named currency manipulators. However, Treasury created a Monitoring List of the countries that fulfilled any two of the three criteria. This list initially contained China, Japan, Korea, Taiwan, and Germany. The October 2016 report added Switzerland, while the October 2017 report dropped Taiwan. Lastly, India was added to the monitoring list in the April 2018 report.

Starting with the May 2019 Treasury report, the US now assesses all trading partners whose bilateral trade with the USD exceeds $40 bln per annum. Before, Treasury assessed the 12 largest trading partners plus Switzerland. Using 2018 data, this new group contains 21 countries that account for more than 80% of US goods trade. The eight new countries to be assessed are Ireland, Vietnam, Malaysia, Thailand, Singapore, Belgium, the Netherlands, and Hong Kong. They join the previous group of thirteen that included China, Mexico, Japan, Germany, Italy, India, Korea, Canada, Taiwan, France, the UK, Brazil, and Switzerland.

Treasury also adjusted the criteria for being named a manipulator. The threshold for the current account surplus was lowered from 3% of GDP to 2%.   The criteria for persistent, one sided intervention was also modified. A country will now be flagged if net purchases are conducted in at least 6 out of 12 months (vs. 8 previously) and these net purchases total more than 2% of GDP over a 12-month period.

We believe that these adjustments reflect the growing clout that the trade hawks have within the Trump administration. With its latest Treasury report, the US is basically put all its trading partners on notice that scrutiny on trade imbalances will get even stronger. As it noted, “Treasury’s goal in adjusting the coverage of the Report and these thresholds is to better identify where potentially unfair currency practices or excessive external imbalances may be emerging that could weigh on US growth or harm US workers and businesses.” Bottom line: trade tensions are likely to remain high until further notice.

Under the new criteria and expanded coverage, the Monitoring List expanded significantly. It is now made up of China, Japan, Korea, Germany, Italy, Ireland, Singapore, Malaysia, and Vietnam. India and Switzerland were dropped in this latest report after both met fewer than two of the three criteria for two straight reports. Korea now only meets one and if this is the case when the next report is prepared, it too will be dropped from the Monitoring List.

 

ECONOMIC OUTLOOK

The US economy remains in solid shape. The Atlanta Fed’s GDPNow model is tracking 1.9% SAAR growth in Q3, down from 2.2% previously. This is still close to trend (~2%) and little changed from the preliminary 2.1% SAAR in Q2. Elsewhere, the NY Fed’s Nowcast model is tracking 1.6% SAAR growth in Q3, down from 2.2% the previous week.

However, US recession risks are rising. The 3-month to 10-year curve inverted to -32 bp today before recovering to -28 bp currently, still overtaking the July 4 cycle low near -25 bp. We acknowledge that the impact of ongoing trade tensions is unpredictable, but it is just the sort of exogenous shock that can tip an economy into recession. Using the shape of the US yield curve, the New York Fed calculates the probability of a US recession 12 months ahead. This fell to 31.5% in July from the cycle high of 33% in June. In light of recent developments, we expect this to rise again in August.

US rates markets have reacted to the renewed trade tensions.  The implied yield on the January 2020 Fed Funds futures contract is currently around 1.49%.  Three more cuts this year are still close to fully priced in, with WIRP suggesting 100% odds of a cut at the next meeting September 18 and 27% odds of a 50 bp move.  Looking further out, the implied yield on the January 2021 Fed Funds futures contract is currently around 1.08%.  This suggests that two more cuts next year are nearly priced in.

Powell admitted at last week’s FOMC meeting that the Fed is still trying to figure out how to react to global trade tensions.  As such, we cannot say what the Fed’s likely reaction function is right now.  Even noted Fed dove Bullard said today that he wants to gauge the impact of the last rate cut before moving again. Markets clearly believe the Fed will bail Trump out again, but we are not so sure.  The Fed should not reward bad trade and fiscal policies with rate cuts, and so we believe the US rates markets have once again gotten too dovish.

 

INVESTMENT OUTLOOK

Trade tensions will continue to weigh on global financial markets. China just put its purchases of US agricultural products on hold. While US officials contend that the next high level meeting with China is on track for September, we think that is very much open to question. Working level talks are supposed to take place in August but no word yet if they are actually being held.

In light of recent developments, we’ve given up any hopes for a US-China trade deal this year. Even 2020 will be tough if things keep going south. Simply put, China will not give in to threats and intimidation and so it will be up to the US to take a step back in order to move the ball forward. President Xi does not have to worry about an electorate and so can play the long game. This means headwind on global trade and growth will remain in place for H2 and into 2020.

Senior China officials continue to downplay risks of weaponizing the yuan. We believe them. Premier Li has promised not to weaken the yuan to stimulate exports. He has also acknowledged that a devaluation will do more harm than good to China, and we concur (consider what happened after the 2015 yuan devaluation).

The dollar has come under some pressure against the majors due to the slide in US rates. When US rates adjust higher as we expect, the greenback should get some more traction.  There has been rising speculation that the US will undertake FX intervention to weaken the dollar. We view this as highly unlikely.

The less dovish than expected Fed, renewed trade tensions, and broad-based risk off sentiment should conspire to keep downward pressure on EM FX and equities.  MSCI EM has broken below the May low near 982 and is on track to test the January low near 945.50 and then the October low near 930. Likewise, MSCI EM FX has broken below the May low near 1609 and a break of the 1607 area sets up a test the September low near 1575.

The correlation between CNY and MSCI EM FX is now around -0.85, which is near the all-time high. That means that ironically, the PBOC has been allowing the yuan to better reflect market forces that impact the rest of EM. While the PBOC may want to discourage capital outflows by keeping the yuan relatively stable, there are limits to this strategy if EM FX continues to weaken as we expect. Another 2% move lower implied by a test of the September lows for MSCI EM FX would suggest USD/CNY rising to 7.15 so.