In this analysis, the Asian wealth management house ponders the investment fallout of a world that in some places is retreating from globalisation.
Here is a detailed analysis of the economic and financial landscape from Rohit Bhuta, chief executive, Crossinvest, a Singapore-based independent investment firm. This publication is pleased to share these insights and invites responses. The editors of this publication are grateful to share such insights but do not necessarily endorse all views from outside contributors.
The US has come full circle, all the way back to Abraham Lincoln’s economic stand from 169 years ago. President Lincoln introduced protective tariffs in the late 19th century on the back of fear that the US was losing its momentum to cheaper manufacturers, mainly Britain. While Lincoln toyed with tariffs, Britain embraced trade agreements, kicking off a period in which global trade grew at twice the speed of GDP, and Britain.
The British raj as a global (trade) leader came to an end post-WW1, the war effectively exhausting its capital. While the US’s momentum began during this time through manufacturing, its focus was more pinned on rebuilding the nation rather than making the most of a global leadership vacuum, leaving the world with no clear economic leader between WWI and WWII. Global trade slipped from around 30 per cent to just 10 per cent of GDP.
The US took over the helm after WWII, by which time it had built sufficient infrastructure, trade superiority and capital. Over the subsequent 70 years, free trade has stood as the cornerstone of the global economy. By 2008, global trade represented 60 per cent of GDP.
The results have been extraordinary - the beneficiaries initially were only those holding the capital, which principally were the US and then Europe and Japan, once rebuilt. Rapid increase in income levels in those countries led to a flow of capital offshore, looking for cheaper labour. This then led to a flow of benefits to emerging economies. Consequently the IMF Global Poverty Ratio tumbled from over 40 per cent in 1980 to less than 10 per cent in 2015, a staggering achievement. This also lead to the emergence of pockets of wealth in countries previously linked to only masses and poverty - China and India.
There has been nothing sinister about this re-distribution of wealth - China and India simply doing what the British did in late 19th century and what the Americans did for the better part of the 20th century. As is so often the case, however, passing on the baton of (global) leadership is not as easy as it sounds. Passing on the baton requires leadership and maturity or the world will be buffeted about by the forces of each country’s self-interest. The baton is not likely to be passed without a fight - “how dare another country do what we have been doing for years?”
The world has benefited significantly from globalisation and free trade whenever there has been a clear world economic superpower - free trade alone though is not enough. Globalisation spreads wealth by allowing production and capital to shift to the most efficient labour markets. Thanks to more open trade markets, the US’s share of global manufacturing grew from 7 per cent in 1860 to 32 per cent in 1913 despite the US having the highest tariff barriers in the Western world. Britain’s prosperity at the same time meant that it was no longer competitive in terms of labour costs and its share of manufacturing fell by 34 per cent in the latter half of the 1800s with most lost to the US and Germany. Inevitably that led to political pressure in Britain and an anti-globalisation movement. Similar movements started across Europe and the US. Then came WWI, the end of British leadership, and trade went sharply into reverse. Sound familiar? Plainly, we now risk this pattern repeating. The parallels between the UK then and the US now are obvious. The US has lost 40 per cent of its global manufacturing share, now slightly behind China at 19 per cent of global output.
The gradual exporting of this wealth from the US, and Europe for that matter, to emerging economies will eventually create too much pain, if it has not already, for Western democracies to bear without them trying to protect their self-interest. Middle class voters in the US and Europe have seen little increase in their incomes since the 1990s, around the time that China’s manufacturing investment boom took hold.
Pressure on free trade escalates during a recession when self-interests peak and so the Global Financial Crisis in 2008 created the beginning of the end for globalisation’s 60-year run. We may now face another "vacuum" period as the US appears, once again, to be shifting back into isolationism. Globalisation is under attack and in desperate need of a global leader to defend its merits. The people of the US have voted not to be that global leader any more. They elected a president on a platform of “America First”, specifically stating that the US can no longer afford to put global interests ahead of its own. While Donald Trump will bring jobs back home (albeit at a significant impact on overall prices and hence impact on consumers), the people of Britain have voted they want to protect their turf.
Similar sentiments are being floated across Europe. China by comparison wants to be the leader, but is it ready? Until a clear global leader emerges, which is not likely to happen anytime soon under the circumstances, protectionism and self-interest may be the order of the day. Political leaders like Boris Johnson (Brexit), Trump (the US), Marine Le Pen (France) and Beppe Grillo (Italy) have capitalised on anger in the developed world about their falling incomes and the impact on the standard of living. They have effectively played on “globalisation”, “immigration” and “free-trade” as the root causes of their predicament and in the process made an enemy of China, India, Mexico and any other nationality or group seen as “taking my job”, when all these countries are doing what the economic powers have been doing for centuries.
“But how dare they take what is rightfully mine?” In a democracy, when enough people want change, they get it. And there are large movements of people led by wily, powerful politicians who are demanding anti-globalisation, even though most don’t understand what this really means. This new phase of de-globalisation will likely be dominated by rising tariffs and nonfinancial trade barriers.
Moreover, it will be characterised by global political tensions, particularly between exporters and protectionists. The two largest net exporters globally are China and Germany. Their combined trade surplus of $760 billion is larger than the next 20 countries in total. Since the start of the GFC, China has increased its surplus by a massive 280 per cent and Germany by 107 per cent. These staggering numbers are fueling the coming trade attacks from the developed Western world.
The case against each of China and Germany is unique but with one common element - both have been accused of manipulating the open global trade and economic system: 1. China. China’s growth model has involved controlling capital flows to force investment in manufacturing capacity and subsidising its exporters whilst erecting unfair tariff and non-trade barriers to imports. 2. Germany. Germany has used its power in the EU to force an inappropriate austerity on its members so worsening an extended recession and helping to hold down the value of the euro boosting Germany’s trade competitiveness. It also has refused to reflate its domestic economy, despite running a fiscal surplus, thereby limiting the EU’s aggregate demand.
Trump initially singled out China as the villain - the US imports twice as much from China than from Mexico and most Mexican exports are from US controlled companies such as Ford or General Electric. While in Europe, the villain is seen to be Germany with its control over the EU and the austerity measures being forced on southern Europe in particular. Then in just the first few days of Trump’s reign, he turned his attack on Germany, claiming they were devaluing the euro for its own benefit. It is no accident that this headline-grabbing attack in turn boosts the European anti-trade, and anti-EU leaders such as Le Pen in France. Our analysis isn’t about what is right or wrong. Instead, we must examine what the likely ramifications will be for the world and for us, as investors.
Until 2009, China’s secret recipe for creating a miracle economy worked wonders: 1. Start with one billion potential workers, the greatest asset for any economy. 2. Stir in a dose of controlled capitalism to unlock the potential of that vast human capital asset. 3. Boost the savings rate by leaving social security safety nets very low. 4. Through centralised control, keep interest rates on savings accounts low. 5. Trap savings in the country in low interest accounts by shutting the door on capital flows out of the controlled environment. 6. Encourage banks to lend those same low interest funds to investment projects in infrastructure, property and factories. 7. Thereby creating more jobs for the one billion potential workers to take up, creating even more savings to pour back into the engine room. Of course, this is grossly over-simplified. But even so it doesn’t detract from our central thesis. But things changed.
To maintain growth in the face of the collapse of the Western world’s demand for their exports, China stepped up its investment spree. Centrally controlled local governments and state-owned enterprises borrowed more than ever to fuel investment projects and China’s GDP continued at 10 per cent and more a year. By mid-2016, China’s total debt to GDP ratio passed 250 per cent. This was around the same level as the US and Europe, but an unprecedented level for a country of the low GDP per capita levels of China. By 2016, $4 trillion in new debt was required each year to keep fuelling its target GDP growth rate of 6.5-6.7 per cent per annum which represented an additional 40-45 per cent of GDP.
And then out of the blue, along came Trump. Initially he was ridiculed, but the American people spoke and Trump won the US election on an “America First” campaign with anti-free trade as its centrepiece. That creates a problem for China. They need a trade surplus of 6-7 per cent of GDP to constrain debt, but to achieve an increase of that magnitude they will need a major increase of Chinese imports into the US.
China’s growth model is facing testing times as it transits from an investment/export-led model to rely more on consumption/services. It faces a difficult period as this transition takes place that requires de-leveraging, structural reform and careful balancing of GDP growth and indebtedness.
While Trump is unlikely to get his proposed 45 per cent tariffs on Chinese imports over the line, there is no chance he will tolerate a rise in US imports from China in his first year of presidency. And while the US is not the only importer of Chinese goods, they are the largest and so achieving such a huge jump in China’s trade surplus while the US is trying to reduce imports is therefore very unlikely.
Is China preparing for global leadership?
Trump’s mantra is “America First”. Based on the anti-free trade bias he has built into his administration already, Trump’s strident promises to retreat from global trade agreements seem likely to eventuate. Meanwhile, and despite China’s woes mentioned earlier, China is turning up the heat on its long-held ambitions to be the new global economic leader.
Premier Xi Jinping has positioned China as a “champion of global free trade” since Trump’s election, adding to the momentum they have already built with their foreign investment strategy (“One Belt/One Road”), the Asian Infrastructure Investment Bank, its unexpected leadership in the war on climate change, and a frenzy of bilateral trade agreements in 2016. Under Xi, China has abandoned the “Deng doctrine” of deliberately downplaying its strength to take a much more aggressive foreign and security policy approach, it is developing a “blue sea” naval capability and is already the largest player economically in manufacturing, commodities, travel and in many consumer items from cars to smartphones.
So, despite the bold pronouncements by Trump and his team, it could be assumed that Trump would be happy to hand over the often-expensive responsibilities of the world’s economic superpower to China. And it also could be assumed given their aspirations that China is both willing and able to take it on.
So is China ready to become the world’s next economic leader? The short answer is a "no", at least not in the short term as it lacks the military power that is a requisite to be the global superpower. In addition, China’s addiction to growth at any cost means they are now too reliant on investment, have too much debt, and have fuelled too much global anti-trade sentiment to allow them to export their way out of trouble, particularly with the impact of the anti-imports/buy-American mantra of Donald Trump.
Tariffs imposed on China is likely to hurt it (and the region) in the short term, irrespective of China’s size and GDP growth. While we are of the view that China’s ascendancy to world leadership is not going to take place in the next few years at least, we think there is a strong chance that they might take over the helm eventually, or at least share global leadership with the US. China’s capital markets, already the second largest equity market and the third largest bond market, is likely to take up a far greater role going forward as China opens up to foreign investors. China is already the largest creditor nation in the world with important implications for foreign direct invesment and portfolio flows while the renminbi is gaining importance as it becomes more volatile. All said and done, a leadership vacuum will remain through 2017 and is likely to have a significant impact on the global markets.
Trump wants less trade and seems prepared to pick a fight in order to achieve his goals. This year will see a colossal trade battle that may spill over into financial markets and impact the real economies of the rest of the world. As Wall Street has already priced in all of the positives from Trump’s presidency, the negatives from this sort of battle may cause significant volatility for equities and commodities in particular.
Implications for investors
China led 2017. This battle between the US and China may damage Chinese interests far more than US interests in the short term but, ultimately, will hurt the US as well. A threat China holds over the US is that they could sell off its massive US debt holdings.
But that would weaken their own capital reserves, further weakening their already precarious position, so they are unlikely to do this. And even if they do, the world is awash with yield-seeking capital, so the US will have no trouble finding alternative sources of debt. We feel that there will be no winners from this battle. Instead we are just talking about varying degrees of loss. US corporations selling into China and those buying components from China will suffer a loss of earnings that could vary from minor to devastating, from company to company.
Overall, equities will fall, but the impact on individual stocks will vary. Investors should therefore take a high-conviction approach. But it must be founded on a genuine understanding that this trade war, and the likely resulting damage to the global economy, will result in a range of risks which will potentially impact earnings over the next decade.
Cautious investors might look to defend against this possible scenario by reducing Chinese assets including the yuan and shifting capital into non-financial assets such as yield assets that aren’t traded on volatile markets, such as property, infrastructure and farmland that offer diversification and a “hedge” against stagflation.