Wasting assets: US-China relations more than just about trade?

Monthly Investment Letter

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In the early 1950s, the US security establishment debated how to conserve America’s “wasting asset” of nuclear superiority, and even considered preemptively striking the Soviet Union before it developed a hydrogen bomb(1).

Seven decades later, the Trump administration is thinking about how it can act to conserve another wasting asset – America’s relative economic size and geopolitical influence – against the rise of China, whose economy is on course to overtake the US’s in the next two decades(2), and on some measures is already larger (see Fig. 1).

Trump administration documents reveal perceptions of China working to “shape a world antithetical to US values and interests…displace the United States in the Indo-Pacific region, expand the reaches of its state-driven economic model, and reorder the region in its favor.(3)” We think that part of the recent weakness in Asian markets is down to investors starting to price in the idea that the US conflict with China will not be resolved with a “deal” before the mid-term elections.

China, meanwhile, is under time pressure of its own. After two decades of impressive growth, Beijing is trying to rebalance its economy, develop next generation industries, and reduce debt-to-GDP levels, all before the next global downturn.

As we have seen on multiple occasions in recent years, rising geopolitical risks need not hurt global markets. But while China has managed its economic transition well since 2015–16, US pressure is making life more difficult. Investors are watching to see if China will be able to successfully achieve its ambitious growth targets and simultaneously deleverage its economy against a more challenging backdrop. Whether or not the pressures on China spill over into global markets, as they did in 2015–16, will be one of the critical issues facing global investors in the months ahead.

In this letter, I review the sources of US-China tensions, look at how these tensions will affect China’s deleveraging agenda, and highlight the key indicators we are watching to judge whether worries about China could contribute to a global market shock.

Last month, we reduced the size of our overweight position in global equities, bringing our overall global tactical asset allocation stance to broadly neutral. This is achieved through a small overweight in global equities, an overweight in emerging market dollar-denominated sovereign debt, and an overweight to 10-year US Treasury bonds. A key reason for our risk reduction was our view that the market was not pricing in the increased risk of the tariff issue. While talks between the US and China have resumed, the US is still on track to impose 10–25% tariffs on USD 200bn of trade with China, and has threatened more. Furthermore, we note that the strong dollar and rising rates environment is revealing weaknesses within the emerging markets complex, contributing to more widespread volatility.

A dispute wider than trade alone

Trump administration documents demonstrate that current concerns about China reach beyond the narrow issue of trade, spanning economic policy, military capabilities, and technology investment.

The US National Security Strategy labels China – and Russia – as “revisionist powers….determined to make economies less free and less fair, to grow their militaries, and to control information and data to repress their societies and expand their influence,” while planning to “challenge American power, influence, and interests.”

The document goes on to criticize a perceived lack of economic liberalization in China: “For decades, US policy was rooted in the belief that support for China’s rise and for its integration into the post-war international order would liberalize China. Contrary to our hopes, China expanded its power at the expense of the sovereignty of others.”

Trump administration documents demonstrate that current concerns about China reach beyond the narrow issue of trade.

In technology, China is said to “every year, steal US intellectual property valued at hundreds of billions of dollars… [and]…unfairly tap into the innovation of free societies.” Even legal information sharing and investments are provoking concern: “some actors use largely legitimate, legal transfers and relationships to gain access to fields, experts, and trusted foundries that fill their capability gaps and erode America’s long-term competitive advantages.”

China’s developments in the South China Sea, meanwhile, are claimed to “endanger the free flow of trade, threaten the sovereignty of other nations, and undermine regional stability.” US Defense Secretary Mattis summarized the US stance: “Great power competition, not terrorism, is now the primary focus of US national security.”

It’s not my place to say whether these pronouncements or perceptions are justified or reasonable. But investors must bear in mind that such concerns exist, are feeding into official US strategy, are tracking closely with policy action, and are sufficiently broad based to suggest they are not going to dissipate easily, or soon. History shows us how previous instances of the US encountering rising powers have shaped outcomes. Fear of communism in the 1940s and 1950s not only led to classified discussions about pre-emptive nuclear strikes, but also to a large increase in defense spending. Japan’s rapid development in the 1980s led to restraints on trade.

Endangering China’s deleveraging goals

The hardening of US policy comes at an inopportune time for China, which had been working to rebalance its economy to enable sustainable long-term growth and contain risks related to its rising debt (see Fig. 2). Oversight of the financial system has been strengthened, regulation of the shadow banking system has become tighter, and banks are writing off more of their bad loans. Sales of wealth management products, a conduit for banks’ off-balance sheet loans, halved last year.

These measures appear to be successful. Since the beginning of 2016, China’s debt-to-GDP ratio has stabilized, showing that a “safe” unwinding of China’s credit bubble might be possible. But the US’s aggressive trade stance is now complicating the policy choices facing China’s leaders, and is posing a challenge to the country’s goal of orderly deleveraging.

Continuing to deleverage would risk a slowdown at a time when the economy may be in need of stimulus to offset US tariffs. China’s ability to advance its strategic overseas goals, such as the Belt and Road Initiative (BRI), also depend on maintaining solid domestic growth.

So China has instead chosen to postpone deleveraging. A series of steps, including liquidity provisions, fiscal policy, and high bank lending to exporters, should offset the near-term impact of tariffs. This may allow China time to diversify its sources of foreign direct investment and continue to reduce dependence on imports through the “Made in China 2025” strategy.

“Great power competition” does not necessarily have to hurt markets.

But deleveraging cannot be postponed indefinitely. And if poorly applied, stimulus could contribute to further yuan weakness. This could exacerbate diplomatic tensions, as most recently occurred when the Trump administration chose to meet Turkish currency weakness by doubling the tariffs on the nation’s steel and aluminum. This in turn caused the lira to weaken further. Investors need to be watchful of a similar dynamic taking hold with China and the yuan. We believe a rise past 7 yuan to the US dollar, especially if broader dollar strength is absent, would intensify concerns over China’s intent and grasp on its currency.

What we are watching

“Great power competition” does not necessarily have to hurt markets. US equity market returns were strong in the 1950s and 1980s despite the Cold War and the US-Japan trade conflict, respectively. So it would be wrong to reflexively sell out of equities due to increasing tensions between two major world powers. Earnings growth is a powerful force, and we expect 6% earnings growth for US stocks and 14% for Chinese stocks in 2019, even when we include the impact of tariffs. Furthermore, while we expect US-China tensions to persist over the medium term, a near-term de-escalation is possible. Mid-level talks on trade have resumed.

Even with increased pressures on China, we don’t expect this to materially impact global markets in our base case. But we are monitoring the situation closely. Between August 2015 and February 2016, the yuan fell by less than 6%, yet global equities were dragged down by more than 15%. In contrast, since April 2018, the yuan has fallen by more than 8%, yet global markets are marginally up. We note, however, that the (90-day) correlation between the Chinese yuan and global equities is currently at its highest level on record (see Fig. 3), demonstrating that markets are sensitive to events in China, even if the net impact on global equities has not yet been material.

We will be watching China’s capital flows, foreign exchange reserves, and high frequency growth indicators closely to judge whether pressures on China could have a larger impact on global markets.

China capital flows and foreign exchange reserves

A key driver of the global market downturn in 2015–16 was concern about China’s capital flows. Between August and December of 2015, capital left China at an annualized rate of USD 1trn, running down FX reserves (see Fig. 4). The eventual “solution” was to tighten control of the capital account. Global markets recovered once they noted that less capital was leaving the system and foreign exchange reserves were stabilizing.

Today, capital looks more controlled, thanks to the measures implemented in 2016 to tighten sources of outflows. FX reserves, though USD 1trn below their mid-2014 peak, have held stable through the most recent bout of yuan depreciation. But this still bears monitoring. A significant escalation in US trade tariffs and broader yuan weakness could upset the balance, and lead to renewed concerns about China’s reserve levels. Additionally, as noted with regard to Turkey, the Trump administration has set a precedent of increasing tariffs into currency weakness.

Chinese high frequency growth indicators

Another key difference with the China-related panic of 2015 is that Chinese high frequency growth indicators are not slowing as abruptly. In 2015, the Citi economic surprise indicator for China plunged from +30 to –120 (its lowest level on record) between April and June. This time, while data has weakened (from +50 to –50 over the past three months), it has not fallen as sharply, and is not surprising as negatively.

While markets have grown comfortable with the idea that the Chinese government is broadly able to control its growth rate, we will be watching to see how the Chinese economy responds to recent stimulus measures. If it does not, fears about the government’s inability to control growth, and China’s trajectory, could increase.

Asset allocation

Global economic fundamentals remain supportive and corporate earnings growth is strong. But global markets do not appear to be pricing in the potential impact of an escalation in the trade dispute between China and the US. As a result, we hold a broadly neutral overall stance on risk in our global tactical asset allocation, comprising a small overweight in global equities and an overweight in emerging market dollar-denominated sovereign bonds.

These positions are complemented with some counter-cyclical positions that are designed to stabilize our portfolio in the event of renewed volatility. These include an overweight in 10-year US Treasuries and for those investors who can invest in options, a put option on the S&P 500.

In the months ahead, a reduction in trade risks or improving valuations may increase the risk/reward for equities. These factors, all else being equal, would encourage us to increase our allocation to equities.

? We keep a small overweight in global equities. S&P 500 firms are on track for around 25% earnings growth in the second quarter of this year, providing strong support, and, while profit growth in the Eurozone and emerging markets has been lower, it remains positive. Economic indicators are also supportive globally, with positive purchasing managers’ index, retail sales, and jobs readings. And global equity valuations do not look overstretched, with a trailing price-earnings ratio of 17 times, 9% below the 30-year average.

? We overweight US dollar-denominated EM sovereign debt. The asset class came under pressure this month amid worries over financial stability in Turkey. But the yield of 5.8% is attractive, in our view, and the EM dollar-denominated sovereign bond index is highly diversified, with 86 issuers and Turkey representing just 3.8%. The asset class is also relatively insulated against continued US dollar strength.

? We overweight 10-year US Treasuries. Over the past month, this position has helped smooth portfolio returns, with Treasuries gaining amid higher equity market volatility. We expect US core consumer price inflation to remain contained after hitting a post-crisis high of 2.4% in July.

? In our FX strategy, we overweight the Japanese yen relative to the Taiwanese dollar. In our FX strategy, our overweight provides a partial cushion against periods of risk aversion in global markets. Japanese investors hold around USD 3trn in net foreign assets – equivalent to around 60% of the nation’s GDP – and tend to return cash home at times of global financial uncertainty. Meanwhile, an underweight in the Taiwanese dollar provides a hedge against escalation in the trade dispute between the US and China, as Taiwan is the most exposed Asian country in terms of value added into Chinese exports to the US.

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1 Marc Trachtenberg, History and Strategy, A “Wasting Asset”: American Strategy and the Shifting Nuclear Balance, 1949–1954

2 5% nominal US growth, and 8% nominal Chinese growth would see China overtake the US by 2033, assuming constant exchange rates

3 United States, US National Security Strategy, 2017