A tit-for-tat trade spat
President Donald J. Trump’s latest round of protectionist measures targets US$ 200 billion of Chinese imports with a 10 per cent tax. This follows tariffs of US$ 34 billion which came into effect on 6 July. A further US$ 16 billion are scheduled for the next few weeks, in what is turning into an escalating trade war. But the actual effect on economies is less than equity market sentiment suggests.
The impact on China
There are two distinct effects of the latest tariffs on China: the impact on the economy and the impact on equity markets. These are not necessarily the same.
The impact on the economy is relatively small at this level of tariffs. We estimate the first round of tariffs to reduce China’s GDP growth by 20 basis points or less. If this trade spat had occurred 5-10 years ago it would have been much more painful given the economic drivers then. Now, China’s economy is more domestically focused and it has diversified its trade partners, including the Belt and Road Initiative.
Sentiment - rather than facts - weighing on equities
In the equity market, the tariffs are weighing on sentiment, indicating a concern that worse may be to come, but the actual impact on company fundamentals is not high as the revenue share of the MSCI China index from the US is less than 5%.
However, some sectors are under more pressure, particularly those with the highest US exposure such as textiles, auto components and tech hardware. Donald Trump’s measures are also specifically concentrating on sectors which contribute significantly to China’s large trade surplus with the US - consumer electronics and IT hardware - which explains some of the volatility in these industries.
Trump’s tariff decisions are very much driven by upcoming mid-term elections in November and his desire to retain control of both houses of congress. This makes it likely that he will keep up the rhetoric at least until after the elections.
Watching the risks
What I’m watching more closely than the tariffs effect is the impact of China’s economic slowdown on the back of deleveraging and reforms. Credit growth is slowing meaningfully, with the potential to spark deflationary concerns. Last time we worried about that was in 2015 when it caused stress in equities and a selloff in risk assets globally. On the upside, China’s Producer Price Index (PPI) is positive and has stabilised at around 3-4 per cent, so China is no longer exporting deflation.
The cooling global trade cycle is a worry. There is a meaningful deceleration of shipment volumes in Asia due to falling demand from Europe rather than the US. This is potentially more concerning because the impact from trade wars is still playing out. Despite this, Asia export growth remains resilient for now.
Reasons to be positive on China
Despite the headlines, there is cause for bullishness on China. The return on equity (ROE) growth rate in China is amongst the best in Asia - and forward estimates suggest it could get better.
ROE is predominantly supported by improving margins driven by factors such as upgrading consumption trends (China’s domestic theme), cost reduction through automation and industry consolidation. A decade ago there were over 200 state owned enterprises, today there are less than half of that, following meaningful M&A activity in recent years. The nature of these tailwinds suggests a sustainable recovery of ROE and earnings across the new China sectors, and not just energy on the back of rising oil prices.
While China is slowing, it is worth noting that this has been driven by segments of the economy specifically targeted by the government’s deleveraging efforts, such as infrastructure fixed asset investments. Private sector manufacturing on the other hand is on the rise, underpinned by the party’s determination to ensure ample affordable funding for Small and Micro Enterprises (SMEs). This is a key focus as China looks for the next decade’s growth drivers.
With risks, come opportunities
Three years ago, investors were concerned about China’s ability to act rather than its willingness. The reverse seems to be the case today; surely a more favourable dynamic. In addition, risks are rising, but so are profitability and returns on equity. All these factors should support valuation multiples, which have already become more attractive across both the onshore and the offshore market.