Investment Strategy:  Third Quarter – Heavy is the head that wears the crowns

Heavy is the head that wears the crown

Those of you who know your Shakespeare will recognise this line about the responsibility of leadership from Henry IV. In one of my favourite cultural crossovers of all time, those of you who know your Stormzy will recognise this line from one of the highlights of his set at Glasto last week. 

I have my reasons and life has its lessons
I tried to be grateful and count all my blessings

But heavy is the head that wears the crown

Sadly the two men wearing the crowns that matter at the moment may have their reasons but no-one else is counting their blessings as the US and China continue to play chicken in a trade war that has potentially ruinous consequences for the global economy. The temporary truce arrived at in Tokyo at the G20 last week is a welcome rapprochement,  but in a dispute marked by its ebbs and flows we still feel a long way from a permanent agreement that satisfies both sides. 

Unlike the old Cold War with the Soviet Union, the US/China relationship pre-The Donald had been win/win. The two countries rubbed along very nicely as mutually beneficial trading partners with  the US consumer providing the market for cheap Chinese goods and the Chinese providing components and cheap labour for US manufactured icons like the iPhone. Business and profit used to be the ties that bind, they are now the battleground. As China developed into the second largest economy in the world and hardliner President Xi Jinping assumed office in 2012 this ‘big brother/little brother’ relationship was already coming under strain but it was the belligerent new resident of the White House who lit the match under the tinderbox. We are back to the bad old days of win/lose with America complaining that China is cheating by stealing US technology and China seeing the US as blocking China’s dream of gaining pre-eminence in Asia and furthering its global influence.  

The simple story on tariffs is that Trump is trying to reduce the trade deficit with China, support US manufacturers and protect US jobs but this is only part of the story. Some of America’s frustrations with its trading partners are justified. China is unfairly distorting global trade by funnelling cheap capital to state firms, bullying private companies and breaching the rights of foreign companies by demanding their intellectual property and technological secrets. China’s strict foreign-ownership restriction laws require foreign businesses to form joint ventures with domestic Chinese companies leading to claims that the Chinese company in effect ‘steals’ the technological IP from the foreign firm. In crucial technologies such as chipmaking and 5G it is hard to say where commerce ends and national security begins, hence the Huawei hoo-ha. 

Superpower arm-wrestles carry the risk of going horribly wrong  and defusing them requires both diplomacy and statesmanship, currently in short supply. Trump is ‘America First’, tired of the US acting as the global policeman and happy to ‘weaponize’ US economic and trade policy, using tariffs and sanctions to extract concessions and impose obligations. Trump needs a boost at the polls prior to next year’s elections and sees foreign policy as his best and easiest bet as he has little room for manoeuvre with domestic policies. He won’t want to risk bringing on a recession or falling stock market though, which perhaps explains his more conciliatory tone in Tokyo. Xi wants to harness the dream of national greatness to justify the total control exercised by the Communist Party with ‘standing firm against US aggression’ a central plank of this policy. Compared to 10 years ago, China is much richer and has a far more formidable military allowing Beijing to be far more assertive, and with huge funds to deploy globally China is ramping up its influence throughout the world. It is forging ahead with its massive Belt and Road infrastructure initiative to connect Asia with Africa and Europe via land and maritime networks and is putting its diaspora and riches to work across political and academic life in the West to promote China’s interests and influence.  With so much at stake, neither Trump nor Xi wish to appear weak in front of their huge domestic audiences.

The devil’s bargain. 

There is a sort of unwritten contract between the Communist Party and the Chinese people; the people are implicitly promised a rapidly improving standard of living but the price is minimal individual rights with no votes, independent judiciary or property rights. This has worked pretty well for 40 years but is under threat as Chinese growth slows under a mountain of debt, mis-allocation of resources and an ageing population.  China should be doing better and in terms of ‘westernisation’ has gone backwards since Xi Jinping took power in 2013, with the State taking an increasing grip on the free market and entrepreneurial culture discouraged. Government-owned firms share of new bank loans has risen from 30% to 70% and the previously exuberant private sector has been stifled. Resources are being sucked up by wasteful projects and inefficient state firms, so debt has surged and productivity slowed. To increase productivity Xi needs to limit the state’s role in allocating capital, allow failing state firms to go bust and free up the Banks and financial markets. Ten years ago this seemed to be Chinese policy but now such reforms seem unlikely. 

Nobody wins unless everybody wins

Thus says the King of New Jersey, Bruce Springsteen, and I reckon the Boss could also apply his home spun philosophy to global free trade and the impact of tariffs. Trump sees imposing tariffs as an easy win for the US but in the longer term he may be mistaken. He erroneously sees having a trade deficit with a country as ‘losing’, despite the trading arrangement frequently being beneficial to both countries. Tariffs are a tax paid by exporters and passed on to consumers in the countries into which the goods are imported, such that  US consumers may end up paying higher prices. This is hardly ideal coming up to an election year for Trump, nor is the potential equity market weakness the trade war engenders. Simplistically Trump would argue that the higher import prices will discourage consumption but life is rarely that simple. Imports are often raw materials or other essential parts of the supply chain for US manufactures, and higher input costs will lead to a rise in final prices. In any case, trade and manufacture is not necessarily a binary relationship. Taking car manufacturing as an example, and as the normally dry as dust New York Times rather lyrically put it, ‘cars don’t come together in one place with one workforce, they are the result of hundreds of companies working together in a supply chain that can snake through small American towns and across oceans’.  

Tariffs have potential benefits but also costs and risks, helping some parts of the economy but simultaneously, and unintentionally,  harming others. US companies could move their manufacturing offshore, tariff free non-US companies could gain an advantage over US companies by having cheaper input costs, domestic US producers may raise prices to consumers now imports are expensive and less competitive. At some point serious retaliation by the Chinese is likely, making the global environment more unstable and less predictable, all of which inhibits investment and stunts growth. One flashpoint which gets little media attention is the huge Chinese holdings of US Treasury Bonds, effectively financing the huge US debt burden. If China turns into a seller then both US public finances, bond prices and the dollar could come under pressure. 

The bottom line is that tariffs are not the magic ‘win/win’ solution Trump is selling to the American public. Quoting from the mighty Howard Marks at Oaktree Capital Management “In this globalized world, Americans can no longer enjoy both the high paid manufacturing jobs they have been and the low cost goods they have been buying of late. The imposition of tariffs cannot solve that conundrum”.  

Start of an Era?

Even if the current dispute is cooled somewhat by the temporary Tokyo truce, trade tensions are likely to become a permanent feature of the global economy. They are one of the few areas in US politics where both Republicans and Democrats can find some common ground whilst voters, thus far, are very approving . The struggle between the world’s two largest economies could well run for many years marking a profound change for financial markets after decades of globalisation. Stable trade relations between countries requires them to have much in common and a shared sense of how commerce should work. The world now has two superpowers with opposing economic visons, a growing rivalry across numerous fields and deep mutual suspicion. Temporary truces and bursts of friendly rhetoric are likely along the way, but Cold War 2 is now underway.

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