US-China Phase 1, Now What?

Now that the long awaited Phase 1 deal has been signed between the US and China (significantly taking place in the White House) and details finally released (in a 94 page document) it’s worth asking whether much has actually changed.  After all, China still faces (high) tariffs on around two-thirds of its exports to the US while the deal does little to end Chinese state subsidies.  In return the US offers little aside from removing tariff increases.  Intellectual property transfer commitments agreed in the deal are mostly not new as China had already addressed most of these. 

Ironically the magnitude of Chinese purchases, ($77.7bn in manufactured goods, $32bn in agricultural goods, $52.4bn in energy and $37.9bn in services to Dec 2021) means that the Chinese State will have to be even more active in influencing its economy.  The reality is that to achieve this is going to be extremely difficult if not highly unlikely though this may ultimately not matter if China is seen to significantly increase its US purchases.

Looking ahead don’t expect China to be as agreeable on a Phase 2 deal; any such deal would touch on far more sensitive issues.  The likelihood of this being agreed and signed ahead of US elections or maybe at all, is low.  However, in the near term, the deal keeps the risk taps open and avoids any near-term escalation while President Trump walks away with another notch on his belt.  What it doesn’t do is stop any of the US non-tariff barriers, export controls etc, that will still hurt Chinese companies and push China to develop its own technology. Chinese growth will not get much of an uplift from the deal while markets have already largely priced it in.

The commitment from China on the Chinese yuan (CNY) looks vague (achieve market determined FX rate, strengthen underlying fundamentals, refrain from competitive devaluations, avoid large scale, persistent, one-sided intervention), but China will at least avoid any sharp devaluations (of the type experienced in mid-2015, Jan 16), not that they would want to do that again given the negative consequences on its markets/economy.  And as it is China has not been intervening significantly in FX markets for a long while so this should not be difficult either.

US-China Trade War: The Gloves Are Off

The US-China trade war took another step for the worse over the weekend. China announced tariffs on the US of between 5- 10% on $75bn of US imports from September.  Chinese tariffs target 5,078 products including agriculture and small aircraft as well as crude oil. The US responded by increasing its tariffs on $250bn of Chinese imports from 25% to 30% while increasing duties from 10% to 15% on $300bn of Chinese imports to the US from September 1.   President Trump initially said he had “second thoughts” on additional tariffs, but these were clarified to state that “he regrets not raising the tariffs higher”.

The gloves are off on both sides. As indicated by the editorial in China’s People’s Daily states that China will fight the trade war to the end while influential Chinese journalist Hu Xijin said that “we have nothing more to lose, while the US is starting to lose China”, highlights China’s tougher stance.  Meanwhile President Trump is looking at the “Emergency Economic Powers Act of 1977” in forcing US companies to quit China.

Asia’s markets have responded in pain, with stocks and currencies falling while safe havens such as US Treasuries have been in demand.  Indeed the 10-year US Treasury yield has fallen to a three-year low.  Markets have priced in even further easing by the Fed FOMC, with almost three rate cuts by the PBoC discounted in by the end of this year.  Equity futures point to a weak opening in US equities today.

One casualty is the Chinese yuan, which took another leg lower today, having fallen by close to 7% since mid-April.  Further pressure on the yuan is likely, but China may not be too concerned as long as the pace of weakness does not get out of hand. China may try to control the pace of the decline to prevent a repeat of the FX reserves drain seen in mid-2015 and Jan 2016. At the least yuan depreciation will act as a buffer for Chinese exporters against increased US tariffs.  However, expect further yuan depreciation to be met with increased criticism and perhaps more US action, with the US already having labeled China a currency manipulator.

Firm China data boosts sentiment

It is turning into a solid start to the week for global equity markets and risk assets in general.  Growth concerns are easing and central banks globally have shelved plans to tighten policy.  Comments over the weekend that finance chiefs and central bank stand ready to “act promptly” to support growth, may also reassure markets. Meanwhile, it appears that the US and China are closing in on a trade deal, with US Treasury Secretary Mnuchin stating that enforcement mechanisms could work “in both directions”, potentially easing disagreement on of the contentious issues between the two countries.

In terms of data and events, US Q1 earnings, US March retail sales and industrial production, will be in focus this week alongside more Chinese growth data, elections in Indonesia and the second phase of elections in India.  In Europe, flash purchasing managers’ indices (PMI) for April will give some indication of whether there is any turnaround in growth prospects.  The news will not be particularly good on this front, but the surveys may at least show signs of stabilisation, albeit at weak levels.

China data at the end of last week was particularly supportive, with March aggregate financing, money supply and new yuan loans all beating expectations.  The data add to other evidence of a bounce back in activity in March, with the official manufacturing purchasing managers index (PMI) moving back into expansion territory.   The data comes off a low base after weakness in January and February, but suggests that Chinese monetary and fiscal stimulus is taking effect, with the economy steering towards a soft landing.

Chinese markets clearly like what they see, with equities maintain their strong year to date rally (The CSI Index is up over 34% year to date) and CNY remaining firm (CNY has been the strongest performing Asian currency versus USD so far this year) though China’s bond market will react less well to signs of growth stabilisation.  Chinese data this week including Q1 GDP, March retail sales and industrial production are set to add further evidence of growth stabilisation, helping to keep the positive market momentum alive.

Fed keeps the risk trade party going

Risk is back on and the liquidity taps are flowing. Fed Chairman Bernanke noted that it is “not obvious” that US asset prices are out of line with underlying values, comments that were echoed by Fed Vice Chairman Kohn, effectively giving the green light to a further run up in risk trades. The last thing the Fed wants to do is ruin a good party and the comments indicate that the surge in equities over recent months will not be hit by a reversal in monetary policy any time soon.  

Aside from comments by Fed officials risk appetite was also boosted by a stronger than forecast rise in US October retail sales, with US markets choosing to ignore the sharp downward revision to the previous month’s sales, the weaker than forecast ex-autos reading and a surprisingly large drop in the Empire manufacturing survey in November.

Fed comments were not just focussed on the economy and equity markets as Bernanke also tried to boost confidence in the beleaguered USD, highlighting that the Fed is “attentive” to developments in the currency.  He added that the Fed will help ensure that the USD is “strong and a source of global financial stability”.  The comments had a brief impact on the USD and may have given it some support but this is likely to prove short lived. 

The reality is that the Fed is probably quite comfortable with a weak USD given the positive impact on the economy and lack of associated inflation pressures and markets are unlikely to take the Fed’s USD comments too seriously unless there is a real threat of the US authorities doing something to arrest the decline in the USD, a threat which has an extremely low probability.

It is perhaps no coincidence that the Fed is attempting to talk up the USD at the same time that US President Obama meets with Chinese officials.  The comments pre-empt a likely push by China for the US not to implement policies that will undermine the value of the USD but comments by Obama appear to be fairly benign, with the President noting that the US welcomes China’s move to a “more market based currency over time”. The relatively soft tone of these comments will further dampen expectations of an imminent revaluation of the CNY.

Are foreign investors really turning away from US debt?

The press has been full of stories about the dangers to US credit ratings and growing concerns by foreign official investors about the value of their holdings of US Treasury bonds.   A combination of concerns about the rising US fiscal deficit, Fed quantitative easing and potential monetization of US debt, have accumulated to fuel such fears. Given the symbiotic relationship between China and the US it is perhaps unsurprising that China has been one of the most vocal critics. I have highlighted this in past posts, especially related to the risks to the US dollar. Please refer to US dolllar beaten by the bears and US dolllar under pressure. However, my concerns that foreign investors have been shunning US Treasuries recently may have proved somewhat premature.

Should China or other large reserves holders pull out of US asset markets, it would imply a sharp rise in US bond yields and a much weaker dollar.  However, it is not easy for China or any other central bank to act on such concerns.  China is faced with a “dollar trap” in that any decline in their buying of US Treasuries would undoubtedly reduce the value of their existing Treasury holdings as well as drive up the value of the Chinese yuan as the dollar weakens.  Such a self defeating policy would clearly be unwelcome. 

One solution that China has proposed to reduce the global reliance on the dollar and in turn US assets was to make greater use of Special Drawing Rights (SDRs) which I discussed in a previous post, but in reality this would be fraught with technical difficulties and would in any case take years to achieve.  Nor will it be quick or easy for China to persuade other countries to make more use of the yuan in the place of the dollar.  The first problem in doing so is that fact that the yuan is not a convertible currency and therefore foreign holders would have difficulties in doing much with the currency.  

Foreign official concerns are understandable but whether this translates into a major drop in buying of US Treasuries is another issue all together.  Foreign countries have been gradually reducing their share of dollars in foreign exchange reserves over a period of years.  This is supported by IMF data which shows that dollar holdings in the composition of foreign exchange reserves have fallen from over 70% in 1999 to around 64% at the end of last year.

In contrast the share of euro in global foreign exchange reserves has increased to 27% from 18% over the same period.  This process of diversification likely reflects the growing importance of other major currencies in terms of trade and capital flows, especially the euro, but the pace of diversification can hardly be labeled as rapid. 

Importantly, there is no sign that there has been an acceleration of diversification over recent weeks or months.  Fed custody holdings for foreign official investors have held up well.  In fact, these holdings have actually increased over recent weeks.  Moreover, the share of indirect bids (foreign official participation) in US Treasury auctions have been strong over recent weeks.  Taken together it provides yet more evidence that foreign official investors haven’t shifted away from US bonds despite all the rhetoric. 

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