15 October 2018
The trade war story continues to dominate headlines, given that it is such a marked departure from global norms in recent decades. As it is hard to see the tit-for-tat trade dispute receding anytime soon, it is important to look at how the clash relates to the US electoral cycle and to Trump’s image as ‘deal maker’, as well as the longer-term impact of the conflict on China, which we believe is often overstated.
US politics and tariff decision making
The US electoral cycle remains a key point of reference for the direction of the ‘trade wars’ story. With the US midterm elections edging closer and Republican control of both houses of Congress at stake, it is hardly surprising that Trump wants to project the image of being tough on trade, as he promised in his campaign. As such, it is likely that this rhetoric will continue to escalate at least until November, and if his party is successful, then trade wars are likely here to stay. But the outcome of the midterms will also impact the decision-making processes of China and other US trade partners - will they negotiate, retaliate, or put off these decisions until the presidential elections in 2020?
Trump as ‘deal maker’
Trump appears to view himself as a ‘deal maker’, so it is possible that his ultimate goal is to strike a historic ‘deal’ with China. After years of rhetoric directed towards the US’ NAFTA partners, Canada and Mexico, Trump forced both parties to the table to renegotiate the 1994 agreement. While the verdict is still out on how much Trump really achieved there, he announced it as a ‘truly historic’ new deal, and as evidence of how his tough talk ultimately leads to deal making. In comparison to China, however, Canada and Mexico are far more reliant on US trade, with exports to the US contributing over 20 per cent to Canada’s GDP and 37 per cent to Mexico’s GDP. As a result, they are much more likely to be responsive to US demands.
This raises the question of whether a ‘winning deal’ with China is even possible. China has effectively diversified its trading partners through such programs as its Belt and Road Initiative. With some of its long-term, strategic plans making progress, it is less likely that Trump has the bargaining power he may have had over China 20 years ago.
Staying positive on China
It must be noted that while GDP in China is slowing, this has been driven largely by segments of the economy specifically targeted by the government’s deleveraging efforts, such as infrastructure fixed asset investments. On the positive side, private sector manufacturing activity is increasing, driven by the party’s determination to ensure sufficient funding for Small and Micro Enterprises (SMEs), which will continue to be a key focus for growth moving forward.
The ‘trade wars’ have driven the recent weakness in Chinese equities, particularly in sectors most exposed to US trade, but to put this in context, less than 5 per cent of the MSCI China index revenue share comes from the US. We therefore believe there is a case to be more positive on China.
The return on equity (ROE) growth rate in China is one of the best in Asia and is supported by structural tailwinds: better margins driven by factors such as improving domestic consumption, cost reduction trends, and consolidation in state-owned enterprises.
In addition, after a nearly 25 per cent drop in Chinese equities since January the price-earnings ratio is now below its long-term average. We believe this represents an attractive entry point for investors looking to get back into the market.
Source: Bloomberg, October 2018
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