Trump Declares War on China

Transcript

The revelation of the full scope and scale of Trump’s new trade war shocked the world this week

Stock markets plunged as investors were reminded of the Smoot-Hawley Tariff Act of 1930 and the collapse in global trade that followed

With the US unemployment rate at just 4%, it is hard to believe that Trump is willing to risk so much just to revive American manufacturing

Is there more to it than meets the eye?

How should you be investing your money right now?

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Globalization means different things to different people.

But if we were to measure globalization in terms of whether world trade is growing faster or slower than world GDP, it would be correct to say that globalization peaked during Trump’s first trade war in 2018. (Chart 1)

Even though globalization has gone into reverse gear over the past few years, Trump’s new trade war is a reminder that we are still living with its consequences, especially political consequences.  

Trump is right that globalization has not been fair.

Globalization was a windfall for some and a curse for others.

Globalization created winners and losers.

While it is too early to say what Trump’s new trade war means for the losers of globalization, especially in the short-term, we can safely assume that it is bad news for its winners.

Possibly very bad news.

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The biggest winners of globalization were US corporations and Chinese workers.

Globalization helped US corporations to break into new foreign markets and increased their wage bargaining power at home.

In other words, globalization allow US corporations to sell more and make stuff more cheaply.

Corporate profits as a share of US gross domestic income have been going up steadily over the past 20 years, hitting a new high in the fourth quarter of last year (Chart 3)

Chinese workers were no doubt also big winners.

As China’s share of global trade increased four-fold since China joined the world trade organization in 2000 (Chart 4), China’s per capita income has increased from less than $1000 to close to $13,000 in the space of just 25 years (Chart 5).

Trump says he wants US and foreign companies to produce more of what they sell in the US in the US

This does not bode well for Chinese workers and US corporations from Apple to Walmart.

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I said last week that China hawks around Trump are on the ascendancy while China doves like Elon Musk are on their back foot.

Coincidence or not, we heard this week that Elon Musk could be soon on his way out.

It was widely reported that Trump informed his close circle that Elon will be leaving soon.

I said last week that if there is a grand strategy behind the seeming chaos of the Trump presidency, all signs are pointing to the containment of China.

I don’t know if Musk’s pending departure has to do with Trump’s China policy, but the biggest take-away for me from what Trump unveiled on his Liberation Day is that his entire trade war may be ultimately directed at China.

To what end?

To inflict a blow to China so big that China will no longer pose a threat to the US hegemony?

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Trump’s first trade war was not a success

This is evidenced by the fact that since 2019, exports as a share of US GDP have fallen while imports have increased (Chart 6)

What’s more, China’s share of global trade is higher now than at the start of Trump’s first trade war (Chart 7)

If Trump first trade war failed, it was because Chinese companies were able to circumvent his tariffs by relocating their supply chains elsewhere (Chart 8)

They were able to continue to export to the US via backdoors such as Mexico, Vietnam, Thailand and Indonesia

Trump’s new trade war is designed to close these backdoors, to leave Chinese firms with no place to hide (thumbnail).

In Trump’s new trade war, Vietnam will be hit by a reciprocal tariff of 46%, Thailand of 36% and Indonesia of 32%.

If Mexico has been spared from Trump’s reciprocal tariff, my guess is that it has a lot to do with the fact that it has agreed to adopt the same high US tariff on Chinese imports. (Chart 9)

Then Trump hit China with a tariff of 34%, on top of the 20% that he imposed two weeks ago.

That is a combined tariff of 54%.

With a tariff of 54% and an average profit margin of 5%, it is difficult to see how Chinese manufacturers can make any profit exporting to the US.

 The message cannot be any clearer: Trump has decided to close the access of Chinese manufactured goods to the US market completely.

54% is a death sentence.

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How bad will Trump’s trade war be for China’s economy?

Exports account for about 20% of China’s GDP.

Direct exports to the US account for 15% of total Chinese exports.

It is difficult to estimate exactly how much China exports to the US via third countries, but let’s assume for argument’s sake that direct and indirect exports to the US together account for 25% of total Chinese exports.

This means total exports to the US could be as much as 5% of Chinese GDP.

With the industrial sector making up about 40% of China’s GDP, this means exports to the US may be more than 10% of China’s total industrial production.

These are big numbers.  

What they imply is that Trump’s trade war will hit the Chinese economy hard.

This is even before we consider the second-round effects of the new tariffs.

China invests more than any other country in the world

40% of Chinese GDP is investment in fixed assets

China is already sitting on massive industrial spare capacity

Trump’s tariff will hit already depressed profitability and returns on investments

It will increase default rates and nonperforming loans

Beijing will undoubtedly recapitalize the banking system if necessary, but it is difficult not to think that we will see a sharp slowdown in investment

Of course, Beijing will try to resort once again to fiscal stimulus

But as the deputy governor of the China’s central bank said last week, China’s overall debt is now over 300 percent of GDP.  (Chart 10)

This makes China one of the most indebted countries in the world.

Trump’s new trade war could well unleash the biggest economic crisis that China has had to face in 40 years.

It might even be designed by the architects of Trump’s trade war with this aim in mind.

We live in a dog-eat-dog world and the China hawks around Trump might have decided this is the only way to contain what many of them see as an “existential threat” to the US

China has only itself to blame for not seeing this coming.

Xi Jinping dragged his feet over dealing proactively with the housing bust.

Will the chickens soon come home to roost?

My guess is that Beijing will have to resort to QE and RMB devaluation.

My quess is that it is only a question of time.

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Trump’s trade war will be equally devastating for many US corporations.

The trade war means they will be selling less and making stuff at a higher cost (Chart 11).

Apple, the most valuable company in the world by market capitalization, immediately comes to mind but Apple is not alone.

Trade war will undoubtedly exert downward pressure on the average profit margin of US corporations. (Chart 12)

My bet is that we will soon see some mean-reversion towards the historical range in the low teens from the current high teens (Chart 12)

This will not be good for US stocks.

Nor will the fact that their growth estimates and their growth premium will very likely go down. (Chart 13)

With anti-American sentiment rising around the world, my gut says Tesla won’t be the only American brand to see a backlash.

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My predictions:

My prediction at the start of the year that stocks would underperform bonds has been proved correct.

Year-to-date, MSCI world is down 5%, while the Bloomberg global aggregate is up 2%. (Chart 14)

With the odds of a recession rising rapidly, I am going to stick with this prediction for now.

But a recession is the least of my concern right now.

Given what has happened over the past week, I am much more worried about a serious and destabilizing increase in geopolitical risks.

What will China, pushed against the wall by Trump’s trade war, do to get even?

Will China make a move on Taiwan? I think not but the chance is no longer trivial.

What will Trump do now that Putin has spurned his peacemaking?

Will China and Russia rally behind Iran that Trump has threatened to bomb if it does not agree to give up its nuclear weapons?

If you asked me this question last week I would have said no, but now it seems to me almost a foregone conclusion.

Actions have consequences.

Trump opened the Pandora Box. The question is whether he can close it again.

With every passing day I am becoming a little more pessimistic that he can.