Wealth Intelligence Weekly 12 Aug 2019
Trade wars and currency wars
Things got wild very quickly. Two weeks ago US equities were at record highs, supported by the prospect of an interest rate cutting cycle and progress in the US-China trade talks. These two assumptions proved wrong. The Federal Reserve (Fed) cut rates as expected, but was reluctant to confirm the further easing markets had priced in. The Fed will probably still reduce rates, but not necessarily by as much as investors want.
The prospect of a near-term resolution in the US-China trade, however, is out of the window. US President Trump imposed 10% tariffs on the remaining $300 billion of goods not currently taxed soon after talks between the two countries failed to break the deadlock. While this is by now a familiar part of the Trump playbook, the Chinese reaction was different. For the first time in 11 years, the tightly controlled Chinese yuan was allowed to weaken beyond the seven to the dollar level. This level is just a number, of course, but was long seen as a red line. The psychological impact for investors and traders is far greater than the economic impact.
Trump accused China of currency manipulation, first on Twitter, and then through an official statement from the US Treasury. During all the years that China did manipulate its currency, the Treasury avoided labelling it as such. (The last time was in 1994.) Calling it currency manipulation now is years too late and inaccurate. Since Trump launched the trade battle early last year, the yuan has lost some 12% against the dollar, somewhat offsetting the impact of tariffs. This is hardly dramatic though. If anything, Beijing has been trying to prevent the currency from falling too much.
Four years ago in August 2015, a small devaluation in the yuan caused great alarm on global markets and fear inside China that capital flight would accelerate. (When people think a currency might weaken, they often try to sell out before it happens, setting off a self-fulfilling prophecy.) Many Chinese firms, especially property developers, also borrowed heavily in dollars, and a weaker currency will make servicing their debt more expensive. Back then, the fear was that Beijing was losing control of its currency; now it is using the currency tactically, and will want to avoid a disorderly decline.
A sharply lower Chinese currency will make its exports cheaper globally, putting downward pressure on global prices, something central banks will view with great alarm. It could also potentially lead to its closest competitors (mainly in Asia) intervening to push their currencies down. Central banks from three Asia- Pacific countries, New Zealand, Thailand and India, surprised markets with rate cuts last week.
As far as the trade war is concerned, the best one can hope for is a ceasefire, since a comprehensive agreement appears highly unlikely in the short term. The direct impact on the global economy can easily be overstated. The average US tariff on Chinese goods will now be 20%. On roughly $500 billion imports, assuming stable exchange rates, this amounts to an extra $100 billion US consumers will have to cough up. (Contrary to Trump's repeated assertions, importers and not exporters pay the tariffs.) This is a lot of money, but a drop in the ocean in a $20 trillion economy that is still posting solid growth. For China, there is some loss of production to other countries, but the country has long wanted to move away from being the world's manufacturer of cheap goods to moving up the value chain. Trade is a relatively small part of both the US and Chinese economies, with exports accounting for 10% of US GDP and 20% of Chinese GDP.
The biggest impact on the global economy therefore is uncertainty. Since companies do not know what the trade regime will look like in the coming years, they wait. Expansion, investment and hiring decisions are postponed until there is greater clarity. Financial market volatility adds to the uncertainty.
In the meantime, companies are also likely to reorganise supply chains to avoid the risk of production concentrated in a country where free trade might be disrupted at some point. For instance, while all the focus has been on the US and China, trade tensions between Korea and Japan have escalated dramatically in the past few weeks.
This process of having more production closer to the end customer, rather than in the cheapest destination, is facilitated by recent technological advances. While not quite the end of globalisation, it amounts to the end of a specific phase of globalisation, where companies stretched their value chains to increasingly produce lower cost emerging markets. This had the benefit of creating jobs in those countries (especially China), lowering costs for consumers in the developed world and fattening the margins of multinational corporations. These firms now face squeezed margins and slower top-line growth amid a weaker global economy. The latter is cyclical, the former seems structural.
The big question now is how central banks will react, seeing as they appear to be the only grown-ups among global policymakers? It is clear by now that there are limits to what central banks can do to raise growth and inflation. However, their actions can prevent things from falling apart. Specifically, they can reduce the risk of financial market stress spilling over to the real economy in the form of a credit crunch or worse.
The pressure on the European Central Bank (ECB) to act is immense as the Eurozone economy is far more vulnerable to a global trade recession than any other major economy. There is also still the possibility of Trump imposing tariffs on car imports from Europe, and of course the risk of a no-deal Brexit shock remains.
The problem facing the Bank of Japan (BoJ) is that in any currency war scenario, the yen strengthens, putting downward pressure on inflation. Problematically, both the ECB and BoJ already have negative interest rates and will have to reach for even more exotic and unorthodox policies. The Fed's dilemma is that Trump has been very vocal in demanding further rate cuts, while it wants to be seen as independent. The case can even be made that he escalated the trade issue with China to force the Fed's hand. In the end, it is the markets and the incoming data that will tip the scales. Further rate cuts can be expected, but since most US consumer loans are linked to bond yields, not the Fed's funds rate, borrowing costs have already declined meaningfully. A typical home loan rate has fallen by a fifth this year, from 5% to below 4%.
The rand breaking the R15 to the dollar level needs to be seen against this backdrop of severe market volatility. Where there is risk aversion, traders sell the rand. August is also summer holiday time in the northern hemisphere, with market liquidity thinner than usual, exacerbating any swings. The overall narrative around Eskom and South Africa's fiscal challenges also don't help.
For rand-based investors, the weaker currency does offset some of the declines of global markets and supports rand-hedge shares. On the other hand, a weak rand tends to be negative for interest rate- sensitive shares and bonds. The Reserve Bank views rand weakness ominously, but in the current climate its response might be different. For one thing, the global backdrop is deflationary, while the oil price has fallen below $60 per barrel. This means upward pressure on inflation is likely to be largely insignificant. If other central banks are cutting left, right and centre, including the all-important Fed, it creates room for the Reserve Bank to follow suit, or risk standing out like a sore thumb. After all, they are cutting for fear of an economic slump; we should do the same.
Things are uncertain and choppy at the moment. The global flight to safety means that $14.5 trillion of bonds trade at negative yields, mainly in Europe and Japan. No major economy has long bond yields above 2.5%. As unpopular as they are now, high-yielding South African assets will appear attractive when the dust finally settles.