Speaking Notes for the AIST Australian Superannuation Investment Conference

4 September 2019, Hobart

I want to focus on two mistakes that I believe many investors are making in relation to US-China trade relations.

The first mistake is under-estimating how persistent the trade war is likely to be.

The second mistake is under-estimating the economic damage the trade war is likely to cause and, by extension, the implications for asset prices.

These errors help explain why financial markets, particularly equities, have been somewhat forgiving of trade tensions to date.

Last week, for example, we saw a 1% rally in US equities on the back of comments by the Trump Administration that they had a phone call with the Chinese about resuming trade talks.

Now, It turns out that phone call never happened, but it shows how markets will rally on even the faintest indication this issue might be resolved.

So what does that imply for markets if they are not resolved?

There has been a tendency for many analysts to view the US-China trade war as a one-off dispute that will be resolved by a deal between the US and China, after which, we all go back to normal.

This view rests on the assumption that it is in the interests of both parties to reach an agreement, although that of course begs the question as to why the Trump Administration initiated the trade war in the first place if it is not in US interests.

People often point to Trump’s transactional approach and tendency to invent crises to suggests that this is all just brinksmanship and that a deal will be struck before the 2020 Presidential election.

I’m going to argue against that view on two grounds.

First, it’s a misreading of Trump’s convictions on this issue, which run deep. Trump views international trade, not as mutually beneficial, but as exploitation and predation, has held that belief for 30 years and is now acting in ways that are consistent with those long-held beliefs.

If you believe “trade is bad,” tariffs are good and trade wars “easy to win,” why would you not want less trade and more tariffs, which is exactly what we are getting.

Trump only very recently acknowledged that the tariffs were having a negative impact on the US economy, but now argues this is necessary short-term pain for what he believes is long-term gain from decoupling the US and Chinese economies.

If you read the US Trade Representative’s section 301 report on China, it presents an extensive inventory of grievances against China. The US negotiating position is one which is asking China to fundamentally change the relationship between the party-state and the economy.

Importantly, the US is not offering to remove tariffs until China is deemed to be in compliance with US demands and this has obviously been a huge sticking point in the negotiations.

President Trump is increasingly in a bind, because in order to justify the damage his tariffs have wrought, he needs to pull-off a substantive deal with China. If he walks away with nothing, then the Democrats can rightly hammer him all the way to November 2020 for having presided over a failed trade policy.

The Chinese obviously know this and are perfectly happy to let the trade talks drag into 2020, with no intention of accepting the more far-reaching of the US demands.

This is not meant to suggest China is in a particularly strong position vis-a-via the US. China’s economy is slowing and the last thing they need is a trade war with the US.

However, since President Xi came to power in 2012, China has been prioritizing party control at the expense of economic growth, which is one of the main reasons China’s economy has been slowing.

So the Chinese will take the hit to growth rather than concede too much to the US.

The politics of the dispute on both sides does not lend itself to resolution, even though that would be in the interests of both sides.

The other reason for thinking this dispute is likely to become a permanent feature of US-China relations is that it is somewhat independent of the Trump Administration.

Even before Trump assumed office, it was widely recognized that China had not evolved the way many of us hoped it would before President Xi assumed power in 2012.

Even if the Democrats had won in 2016, or if they win in 2020, the US was always going to recalibrate its relationship with China to reflect China’s change in direction.

It would have been better if the US had prosecuted its case against China through the World Trade Organization and as a member of the Trans-Pacific Partnership.

But in any event, there is no doubt the US, along with the rest of the world, was eventually going to have confront China, having collectively failed to hold China’s feet to fire of WTO rules since its accession in 2001.

So the trade war is here to stay and China has already slipped from its position as the number one trading partner of the US. The decoupling of the US and China is underway.

The second mistake is to assume that the economic fallout is confined to the tariffs themselves, even though the tariffs represent $86 billion in new taxes on US consumers and business.

The larger economic cost is the increase in policy uncertainty, which weighs on business investment globally, which in turn weighs on industrial production and global trade.

The tariffs themselves are a second-order issue compared to the tearing up of the rules-based, multilateral trading system.

The Global Economic Policy Uncertainty Index has been at record highs, higher than during the GFC, 9/11 or any other shock since 1997.

I published a paper in the Australian Economic Review back in March, titled “State of Confusion,” that quantifies the effect of economic policy uncertainty on global industrial production and global trade, as well as Australian macro variables, including exchange rates and interest rates.

A one standard deviation shock to policy uncertainty lowers global IP by 0.4% and global trade by 0.6% within six months.

For Australia, financial markets carry the burden of adjustment, so the real effective exchange rate declines 1% and the real three-year bond yield declines 20 bps, which is pretty consistent with what we have seen recently.

The way to analyse the effects of the trade war is through the lens of policy uncertainty, and if that is not a feature of your macro models, you are not going to see the fallout from the trade war until it shows up in the macro data, by which time its all over from an asset pricing perspective.

Even without the trade war, the world was already facing a cyclical slow-down coming out of China, the trade war simply adds further momentum to that downturn and is enough to push the global economy into recession, a recession President Trump will now own regardless of the deals his does from this point.

From an asset allocation perspective, US dollar denominated fixed income assets will do particularly well in this environment. That is partly a monetary policy story, but is linked to the trade war.

The Australia dollar exchange rate will carry the burden of adjustment for us, so I would not worry about hedging offshore exposures at this point, I would position for an uplift in the AUD value of offshore assets.

The RBA will drag the chain in responding to the downturn and will ultimately have to move much more aggressively than it has to date, so getting out in front of the RBA is also a good idea. I have a USSC report on the Lessons from the US Experience with QE for Australia that I would commend to you if you want to understand how QE will work here.

For equity exposures, I would favour low vol stocks, notwithstanding the fact I like low vol equity anyway.

I don’t think long-short equity will be of much value in navigating the trade war, its effects are too far reaching for that to work effectively.

If you allocate geographically, I would also under-weight China given the party-state in China will have to increasingly sacrifice economic growth to maintain political control, not least in light of developments in Hong Kong.

The dilemma for the Chinese Communist Party is that the more they sacrifice growth to maintain control, the further they delegitimate themselves, requiring even tighter controls, so this has the potential to become a downward spiral that will see investors increasingly re-evaluate the China growth story going forward.