March 26, 2018— President Trump tweeted on March 2 and 7, respectively: “When a country (USA) is losing billions of dollars of trade with virtually every country it does business with, trade wars are good, and easy to win.  Example, when we are down $100 billion with a certain country and they get cute, don’t trade with them anymore – we win big.  It’s easy!” and, “The U.S. is acting swiftly on Intellectual Property theft.  We cannot allow this to happen as it has for so many years!” 

Goldilocks interrupted?

Despite somewhat stretched valuations and a recent bout of elevated market volatility, risky assets have enjoyed a nice tailwind of improving and synchronized global growth prospects, steady earnings growth, muted inflation, ample liquidity provided by global central banks, and generationally low interest rates.  This tailwind is further supported by evolving benefits from tax reform as well as the possibility of extending the U.S. economic cycle with a robust infrastructure program. If these developments combine to prolong the not-too-hot-not-too-cold Goldilocks environment and push a recession into the next decade, should we be on the alert for signs of a non-recession-led equity drawdown?

The greatest wealth transfer in history

One risk that WTIA has previously identified in the 2018 Capital Markets Forecast was the possibility that a “policy misstep could be made in regard to trade.” Enter Trump’s tariff on $50 billion worth of imports from China, announced on March 22.  The pummeling could well be seen as one outcome of an investigation of Section 301 of the Trade Act of 1974 by U.S. Trade Representative Robert Lighthizer, “extracting recompense for theft of intellectual property and investment policies that make technology transfer a precondition for doing business in China.” [1]  Lighthizer proposed a list of over 100 products subject to 25% duties in the aerospace, information, and communications technology, and machinery industries that Trump argues were developed by using trade secrets that China stole from U.S. companies or forced them to hand over in exchange for access to its massive market.”[2]  A pair of former U.S. intelligence officials estimated a cost of up to $600 billion a year for China’s theft of U.S. intellectual property, or “the greatest transfer of wealth in history.”[3]  

Not Lighthizer’s first time at the tariff rodeo

During the Reagan administration, then-deputy trade representative Robert Lighthizer along with his ally former Senator and U.S. Trade Representative William Brock, were instrumental in capturing concessions from Japanese automakers accused of unfair trade practices and threatened with significant tariffs.  Though U.S. – Japan auto disputes continued well past the Reagan administration, Brock and Lighthizer’s efforts laid the groundwork for eventual significant production of Japanese and German autos in the U.S. In 2015, Japanese manufacturers—Honda, Toyota and Nissan—built more cars (not including light trucks) in the U.S. than General Motors, Ford and Fiat Chrysler. German automakers already produce 900,000 vehicles in the U.S., 62% of which are exported.[4]  Despite Lighthizer’s prior negotiating success, New York Times author Ana Swanson on March 9, 2018, alerted readers that “Robert Lighthizer just became one of the most powerful people in Washington.”[5] 

Leveling the playing field: concessions from China or trade war?

A number of articles in the financial press on March 14 and 15 suggested the equity markets shrugged off trade war concerns following reports of a new set of tariffs targeting China. However, “metal bending (steel and aluminum) is not the most worrisome new area for protectionism. Trade in physical goods and services has been flat for years, but digital flows of commerce and information have risen by 45-fold in the past decade, according to the McKinsey Global Institute. The trade war to fear is not in physical commodities, but in technology, which economic nationalists hope to ringfence in order to stave off competitive threats from countries such as China.”[6] 

Though free traders, fair traders and protectionists generally agree that the US-China playing field needs leveling, the dispute amongst the different players is how to accomplish this, but Lighthizer makes clear that nothing is off the table, in a speech at Georgetown University’s Center for Strategic and International Studies: “We must use all instruments we have to make it expensive to engage in non-economic behavior, and to convince our trading partners to treat our workers, farmers, and ranchers fairly. We must demand reciprocity in home and in international markets. So expect change, expect new approaches, and expect action”.[7]

China’s reaction and response

Li Keqiang, Premier of the State Council of China, extended an olive branch by pledging that it will further open its economy, including the manufacturing sector, and reiterated that it doesn’t want to see a trade war.  “There’s no winner in a trade war, and war is going against the rules of trade, which is based on negotiation, consultation and dialogue,” Li said Tuesday at a press conference at the close of the annual National People’s Congress in Beijing. China wants balanced trade and also wants the U.S. to ease restrictions on technology exports, he said.[8] That was on March 20.

But after rubbing $50 billion worth of salt in the wound in the wake of the metals tariffs leveled earlier this month—China counter-punched with tariffs on $3 billion worth of U.S. imports, including pork, recycled aluminum, steel pipes, fruit, and wine. It’s rather tepid, as retaliation goes, but it’s certainly within their purview to make this simply an initial response. Time will tell as far as what lies ahead.

Beyond trade—China as a strategic rival

Further complicating the escalating trade dispute between the U.S. and China is the fact that digital cross border exchanges are not part of the World Trade Organization (WTO) system. And second, the Trump administration has invoked national security issues by opening up an investigation titled, “The Effect of Imports of Steel on National Security” under Section 232 of the Trade Expansion Act of 1962.

“The next action on the president’s plate will be the Section 301 action which is designed, in a laser beam way, to address the issue of forced technology transfer, theft of intellectual property, and China’s bid through the China 2025 architecture plan to capture the emerging industries of the future,” the senior official said. [9]

The White House National Security Strategy facilitated the get-tough approach by designating China as a strategic rival. Trump’s administration is concerned that if China takes control of industries of the future, such as robotics and artificial intelligence, “America will not have a future, at least economically,” the senior official said in an interview. “So that’s where we’re going next.”

Core narrative

We are currently neutral weight U.S. equities and overweight international developed and emerging markets equities. We have previously specified a series of risks to our outlook that included one particularly risk as “a policy misstep could be made in regard to trade.” In light of recent developments, along with a continuing shake-up of players in the White House, we now view downside risks as more pronounced than they were a year ago, though a trade war is still not our base case. Trade negotiators from the U.S. and China have stated their desire to avoid a trade war, but it is also unlikely that China stands by idly without responding to further provocation. Presently, corporate fundamentals and global economic growth remain sound, suggesting upside for equities, though likely with continued bouts of volatility. We are maintaining our equity overweight at this time and will carefully monitor new developments along this particular fault line as we assess the overall balance of opportunity and risk in our portfolios.

This blog post is the third in a series of trade-centric posts:  Rhea Thomas’ “Tariffs by the Numbers” of March 13, 2018 and Clem Miller’s “Trump & China: Trade Deals or a Trade War?” of January 11, 2017.

 

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[1] Bloomberg News: China Pledges Action on Tech Transfer as Trump Plans Tariffs (1)

2018-03-20 08:00:00.22 GMT

[2] Washington Post: Trump prepared to hit China with $60 billion in annual tariffs By Damian PalettaSteven Mufson and Josh Dawsey March 19 at 5:25 PM 

[3] NY Times: China’s Intellectual Property Theft Must Stop.  Dennis C. Blair and Keith Alexander 8/15/17.

[4] BCA Research. Global Investment Strategy Weekly Report March 9, 2018.

[5] NY Times: “The Little-Known Trade Adviser Who Wields Enormous Power in Washington” ANA SWANSON.  MARCH 9, 2018

[6] Financial Times. “US protectionism could set off a digital trade war”.  Rana Foroohar. March 11, 2018.

[7] www.csis.org U.S. Trade Policy Priorities: Robert Lighthizer, United States Trade Representative September 18, 2017

[8] Bloomberg News: Li Says China Will Keep Opening and Wants to Avoid Trade War  3/20/18.

[9] Washington Free Beacon. After Tariffs  Trump to Punish China for Intellectual Property Theft. Bill Gertz 3/12/18