Trade War – Continued Economic and Financial Market Volatility Creates Pressure to Settle – or If Not, Will Trump Run Again?

Using Tariffs to Resolve More Than Trade Issues

Our 10/17/2018 commentary, Will the Trade War between the U.S. and China Grow into Cold War II, outlined aggressive trade and military actions taken by the United States to both make resolving trade issues more difficult and at the same time bring these issues to a head. The administration uses higher tariffs, both imposed and threatened, as a means to revise our broad relationship with China, including both economic and security issues.

Headlines from the Trade Negotiations Will Continue to Create Financial Market Volatility

The headline battles will not only arise from negotiating teams of both countries but within each countries negotiating teams. For example, the White House seems to use a “good guy – bad guy” negotiating approach. Recently, the chief American trade negotiator stated March 1 would be a hard deadline for reaching a trade deal with China — implying the U.S. would then impose higher tariffs. At the same time, Larry Kudlow, Director of the National Economic Council, said: “the President has indicated if there’s good solid movement and good action, he might — he might — be willing to extend the deadline 90 days.” Similar divisions may also be true within the Chinese negotiating team. An Asia Time’s article reported, “yet in a rare admission, Xi acknowledged divisions within his own staff during ‘small talk’ with Trump over dinner.”

Pressures on President Trump to Settle

In our view, both presidents Trump and Xi need an overall settlement for their own individual reasons. With the U.S. Presidential Elections less than two years away, positioning for re-election will likely determine many of Trump’s important decisions. To improve his chances for re-election, he needs to avoid an economic slowdown caused by a continuing trade war. Interestingly, China showed it understood U.S. political geography. This manifested itself when China imposed retaliatory tariffs on agricultural imports from the Midwestern states captured by the President. In the recent mid-term elections, the overall vote in some red states shifted to the Democrats. This shift would reverse the electoral vote outcome of the 2016 election (see Figures 1 & 2). Therefore, in our view, to improve his reelection chances, the President needs to take the trade issue off the docket much before the 2020 election. As a result, we would expect the President to find his way to an agreement with China.

Figure 1

Electoral College Outcome in 2020 Based On 2018 Midterm Results

Source: Deutsche Bank Research

Figure 2

Electoral College Outcome 2016

Source: 270towin.com

Pressure on President Xi to Settle

The Chinese economy recently showed its lowest growth rate in a decade (see Figure 3). Recent reports also show deterioration for industrial production and retail sales (see Figures 4 and 5). The top rulers of China tend to focus on employment growth as one measure of social stability. On that issue, the job market in China appears to be weakening (see Figure 6). Increasing unemployment could become a potential issue for President Xi if it leads to greater social instability. These troubling trends could incentivize the Chinese leader to attempt to find a means to placate the U.S. administration. If so, President Xi must achieve an agreement without appearing to lose face with his own people.

Figure 3

China Activity is Softening

Figure 4

Source: The Wall Street Journal

Figure 5

Source: The Wall Street Journal

Figure 6

The Role of the State in the Economy — Possible Reforms Resulting from Trade War Pressures

The trade war pressures may cause Chinese leadership to reexamine the Communist Party’s role within the economy and society. Many in China call for reforms to boost the private sector, open markets, and meet some of the American concerns outlined by the U.S. administration. During the week of December 17^th, an important meeting of the central economic work conference will be held in Beijing. Out of this conference comes a 12-month plan. With the current pressures from both within and outside China, the outcome of this conference may provide some guidance as to whether China will be prepared to make important reforms.

Reaching Out to the United States with Change

At the same time, China seems to be moving towards reducing differences with the United States. For example, according to The Wall Street Journal, China may develop a new program to provide greater access for foreign companies. The key issue for the United States involves protecting the intellectual property of American corporations and not forcing U.S. companies to transfer their technology in order to operate in China. In the past, China outlined similar types of reforms which eventually did not live up to expectations. The proverb used by President Reagan to deal with the Soviets — “trust but verify” — might apply. Finally, The New York Times quoted the Executive Dean of the China Institute for World Trade Organizations, Tu Xinquan, who said “the Chinese government really wants to negotiate a deal with the United States to calm down the conflict, not only because of economic difficulties right now in China but also for the sake of long-term relations with the United States.”

“Made In China 2025” – Real Change or Just a Name Change

China seems to be pulling back from its “made in China 2025” industrial policy. Much of this policy focuses on making China a leader in high tech industries. In part, to do so, China provides state subsidies to private companies. Many observers remain skeptical that China will make substantive changes to this program with the exception of changing the title. President Trump said, “China got rid of their China ’25 because I found it very insulting.” We suspect he found it insulting because China’s goal to top the U.S. in technology by 2025 meant they would do so during the Trump administration ending in 2024 — assuming his reelection.

Investment Conclusions

We appreciate the bearish message stock markets seem to be delivering with respect to slowing global growth. In part, because of those growth concerns, we remain cautiously optimistic that both countries will see a need to produce a broad trade agreement. We would also note, with a smile, that more than any recent president, President Trump seems more attuned and reactive to the direction of equity markets.

The importance to the global economy and financial markets of a reasonable settlement cannot be overemphasized. Without such a settlement, the U.S. would likely raise tariffs on all Chinese imports. Obviously, China would retaliate in some form. As important, Cold War II would surely unfold between the two countries. With the dark possibilities likely from failing to agree, we will retain our cautious optimism that there will be a settlement. We base this on the reasons outlined in this commentary — not on hope. Lacking a settlement, the potential negative economic outcome, might increase the probability that President Trump will not run for a second term in 2020.

Because of the unsettled trade war and the likelihood of economic slowing sometime in 2019 from Fed tightening, our cautious investment strategy remains unchanged. That strategy called for an equal asset mix of equities, alternatives, and short duration fixed income securities. One possible strategy reconsideration will be whether to lengthen the fix income duration. This possible change reflects the likelihood the Fed ends its rate hikes some time in 2019. However, a change in our view also depends on whether we can avoid upward rate pressures from both inflationary wage increases and funding rapidly growing Federal budget deficits.