The following is the opinion of Richard Kilbride, Managing Director and Fixed Income Specialist at Roosevelt Investments.
When we all said that a US-China trade deal was priced into the market, we were right. Now that that tension is front and center, it has stirred significant angst. Even if this is just a negotiation process, it isn’t transitory. The process to a fairer, but still free, trade system is a long way from a firm foundation.
The path of least resistance is to lower bond yields. Already underperforming global growth and absent inflation drive that too; inflation has been below 2% for a decade. That trade disputes will raise the cost of goods is not the immediate concern. Older folks remember a bi-polar world, two spheres of influence, one headed by the USA and the other by the Soviet Union. Separate, rarely cooperating on anything, and missiles at the ready, that world saw other countries pick sides as the two superpowers vied for influence. If you are an economist, and not a political scientist, the West won because they had better access to financing. Yes, the West also had better laws, standards of living, and better human rights, among other advantages. But it also took almost 50 years for the West’s advantages to play out and maybe it was nip and tuck there for a while.
The US and China have been seeking to play nice together in the global sandbox for some time. China’s joining the World Trade Organization (WTO) in 2001 was perhaps the biggest step. But quite quickly, by as soon as 2007, China’s wealth had grown such that many market prognosticators viewed the Chinese funding of both the US trade and budget deficits, effectively in exchange for their export goods, as unsustainable. Together it all balanced of course, as significant Chinese savings were deployed to buy and hold US securities. We bought their goods, and lived beyond our means, in exchange for them holding our paper. For the Chinese, producing export goods created employment in the great eastern cities as their population moved away from agricultural pursuits.
Enter the financial crisis in the West, which has been blamed on derivatives, or that housing prices had been too high, or on flawed mortgage lending practices, or on liar loans and people borrowing too much, or on inept regulation, or on government policies that over-supported housing and homeownership, or that rates had been held too low leading up to the crisis and investors had been forced to stretch for yield, or that Wall Street firms had too much leverage, or the accounting rules that forced mark-to-market practices creating effective margin calls, or maybe even that Lehman never built enough capital after Bear folded. We’re still working out this narrative. But China’s role and influence got lost in there, and all along containership after containership landed goods here. After the WTO negotiation, China was to open its market. It became the world’s biggest exporter (13% of the total), home of 12 of the world’s 100 most valuable listed companies, and they created enormous prosperity. And if it was simply a matter of Chinese buying US bonds and the US buying Chinese goods, all would be well.
The tensions go beyond that. There are strong views that China didn’t follow the plan. Instead of being a responsible participant in the international order, Beijing has used its new economic might to launch a drive against Western power and primacy that appears as if it could define world politics for decades. In the West, this has stirred up forces hostile to foreign competition and suspicious of free trade. At the same time, markets have been clearly signaling that many of the S&P 500 constituents might be a lot more closely interconnected with China than previously believed. Further, a wealth of academic and policy research over the past generation has shown that globalization tends to raise, not lower, productivity and average incomes. Incomes tend to increase the more that companies and countries are connected to the global economy via international trade, investment, and immigration. This clearly reflects that the forces of globalization should be a very positive thing. Globally, billions of people have been lifted out of poverty in the last generation. Life spans have risen, hunger is down, illiteracy is down, and child mortality is down. Critically then the economic policies that boost growth in productivity and thus in average incomes look to be global policies. This is as old as Ricardo, and still true.
In some countries, some dimensions of globalization—for example, China’s growth in exports related to its membership in the WTO—have put downward pressure on the wages of some workers. Many Americans lost jobs, and though that isn’t the problem as much today, memories and tensions linger, and victims need a scapegoat. Of course, worker productivity is shaped by many forces other than globalization, such as education and technology. But policies related to trade can often be shifted much more quickly and less expensively compared with longer-run, productivity-shaping policies, such as schools or worker training. So, we arrive at the globalization paradox. We know the clear merits to globalization and yet global policy is drifting away from support. Even though all the dynamism that globalization fosters raises average incomes, anxiety about who plays fair is pushing many countries away from rather than toward the policies of more globalization. By turning countries inward, disaffected labor-market performance - part of what drives the anxiety - may even be accelerated.
The western relationship with China seems to be the bet that failed. The expectation was that putting China in the WTO, and other such institutions, would bind China into the rules-based systems set up after WWII. Instead the rules for global trade have been upended as China wishes to play by its own rules. Further, it was hoped that economic integration would encourage China to evolve towards democracy; as they grew wealthier, its people would yearn for democratic freedoms, rights, and the rule of law. Instead, any hopes of movement towards constitutional law has been replaced by politics and economics being steered towards repression, state control, and confrontation. The West was wrong when it expected China to tilt towards a more market-based economy.
This leaves the West and China as ideological and economic rivals. This strain is about the direction, speed, and end game for the relationship, and for our focus, the markets. At a minimum, Beijing is encouraging the spread of authoritarianism. Chinese businesses are arms of state power, including industrial espionage and state-sponsored raids on intellectual property. The Chinese Communist Party’s powerful departments that control personnel and policy don’t exactly list their phone numbers or display signs outside their offices. All the operations are silent. What can resolve this? We know globalization works, but US policy cannot be offering people more globalization only. When people say they are worried about the ability to compete and have their intellectual property protected in the global economy, they tend not to like being told that more globalization and competition is the answer. We also need an array of related policies to allay the unfairness that firms and people experience. Are there still rules? Can we negotiate rules when counterparties renege on previously agreed-to items? How much should we look the other way on IP, forced technology transfer, and subsidies to secure a deal? How do we make progress on these critical items while still allowing the Chinese side to save face, a very important and overarching factor in their culture. These are difficult matters to resolve.
This may be a muddle, a long muddle. The US-China negotiations have been thwarted by miscalculations and unfulfilled expectations. We are interconnected, but we are in competition too. While the longer the impasse, the greater the economic fallout for all, we also need to know if everybody is playing by the same rules, rules which will benefit the greatest number of people. At its heart, the squabbles are over things like 5G, artificial intelligence, and other data-driven services. These are things that we have not yet even figured out much less do we understand their long-run impacts. And as these bridge the cyber line between military and commerce, economic considerations overlap with national security issues. It’s hard to expect anything but a long impasse; perhaps some cease fire pacts along the way, but a very difficult risk for global economies, central banks, and markets. We can hope this all eases, but there are no illusions here, and hope is never a good trading strategy.
The opinion of Richard Kilbride does not necessarily reflect the views of Roosevelt Investments.
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