Trade War

The trade war continues to escalate. Following a first round where the US imposed tariffs on some 50 billion dollars’ worth of Chinese goods, and China retaliating with its own tariffs, President Trump has threatened tariffs on a further 400 billion worth of Chinese goods. Trade wars hurt everybody and tariffs are not a very effective weapon of trade war. In a world of globally integrated supply chains, trade tariffs designed to impact certain parties end up impacting all parties in the supply chain unpredictably. With that caveat and with a great deal of generalizing, we can arrive at a few good guesses.

• A successful trade war is good for the USD. The US is a big net importer and if successful, a trade war will reduce the import of goods and thus also the export of dollars. A shortage of offshore USD liquidity will cause short term dollar interest rates to rise.
• Domestic companies will be more insulated than multinationals. This is an over-generalization but smaller companies tend to be more domestic focused and large, index component companies tend to be more international.
• Luxuries will outperform as they are Giffen goods and higher prices may stoke higher demand.
• Trade protectionism is inflationary in an unhealthy way. A successful trade war will result in a smaller surplus for exporters like China and Japan which could reduce demand for US assets like treasuries. Higher inflation and lower demand for treasuries could lead to a steepening of the yield curve.
• It could encourage further re-shoring to avoid punitive tariffs. This could encourage more investment in the US to substitute away offshore capacity. It could drive wages up although there will be leakage as the US will tend to invest in more automation than a developing country.
• The main protagonists in this trade war are the most resistant to it. The US and China have prepared well for this confrontation by reducing reliance on trade (that is, (exports + imports) / GDP). China’s total trade as a percentage of GDP has fallen to below 30% and the US to below 40%. Trade reliance in Europe is over 80%. Despite the reduced reliance on trade, both China and the US will likely experience a slowdown on account of the trade war. It is unlikely that the current tariffs will tip either country into recession although further escalations could have damaging consequences. For now, look for a cyclical moderation in growth in the coming quarters.

Banks

Last week the Fed concluded a round of stress tests which saw the majority of US banks demonstrating sufficient balance sheet strength to weather a financial crisis. The stress tests are a precursor to the potential for generous dividend payouts to shareholders over the coming year. As second round of stress test awaits before the capacity for capital returns can be finalized.

Oil

Oil inventories peaked in March 2017, yet the oil price only bottomed in June. Inventories staged a weak recovery in response to higher prices in the first 5 months of 2018 but have begun to shrink again.
OPEC and Russia met late last week and agreed to a 1 million bpd increase in production although it is unclear how this will be allocated between members. Capacity constraints mean that the effective increase will likely be closer to 700,000 than a million. Oil prices rallied on the news. The market is split between increasing US shale supply and the eventuality of decreasing non OPEC ex US production as a result of underinvestment. US shale production is being raised through working existing reserves harder rather than significant new finds.

China

The PBOC eased the required reserve ratio for the largest banks by half a percent in an effort to shore up liquidity. The trade war between China and the US has taken its toll on debt and equity markets at a time when China is trying to re-organize its credit transmission infrastructure. The PBOC has been diverting credit away from non-bank channels such as securitization and off balance sheet vehicles towards the formal banking system where it can manage funding and liquidity more effectively. The latest move is an effort to restore calm to markets as well as to further this formalization of credit transmission in the banking system. The move will inject circa 700 billion RMB of liquidity into the system.