Part 4 - Understanding a Trade War Between Australia's Biggest Investor and Australia's Biggest Trade Partner
This is the fourth and final installment in a series of articles that look to explore the potential impact, both short and long term, of a trade spat between Australia’s largest investor and Australia’s largest trade partner. This installment looks at how the conflict might actually play out; perhaps more importantly, we touch upon what the impact will be on Australia.
This week we continue the story of the evolving trade saga and wrap up this series. Two new headlines this week illustrate, as well as make poignant, many of the points we have been making throughout. The first is Trump’s visit to the UK with hopes of restricting that particular country’s use of Huawei equipment in the rollout of 5G and the second being Australia’s aluminium exports to the US trebling in the space of months as a result of the administration's ongoing trade disputes with Canada. The interesting point about the second headline, though seemingly having no relationship to the ongoing dispute with China, is that the actors who ensured that the ire of the President wasn’t drawn as a result of the increase in Australian exports were the officials at the Pentagon and State Department. It goes to show that trade taken as a whole is not a simple question of economics but rather one part of a whole plethora of issues that range from geopolitics, defence interests and national security.
In a similar vein, convincing the UK to abandon their plans of using Huawei in the roll out of 5G is not a simple question of blocking the Chinese company’s advance or protecting US commercial interests in the short-run but part of an overall strategy to vie for leadership in the 4th industrial revolution. In the lead up to G20, the administration is trying to Trump up (pun intended) support and leverage in negotiating with their counterparts. Likewise, China have been using their own soft power to counterbalance these issues, firstly through the strategic use of infrastructure spending (namely the Belt and Road Initiative with Italy and Eastern Europe being prime targets) as well as overt policies to get the UK to undermine the United States’ actions by positioning themselves to appear crucial to their post-Brexit world (after all the UK can scarcely offend a key trade partner that is likely to be made even more crucial to their economic future).
Where to from here?
We ended Part 3 by suggesting that this issue is not likely to be resolved any time soon. In fact, the incentives of the negotiating parties are quite disparate if not in stark contrast to one another. While the Trump administration is likely to want a quick outcome, this can include a quick escalation of tensions to an all-out Trade war or resolution in the form of a deal, the Chinese are incentivised to drag this out. This makes it, in our opinion, increasingly unlikely that a substantive deal will be reached at the G20 in Japan. We would suggest that any such solution is not in the long-term interests of any of the parties involved, after all we live in a complex globalised world where, negotiation and the particulars of any deal should take time to be truly nuanced enough.
While it might be more sell-able to simply look at trade statistics and slap on tariffs at will (which the Trump administration has been prone to do), global value chains are too complex for such black and white policies. For one, how can one truly account for the long-term ramifications for the US economy of access to $517 billion in sales revenue, which is what US companies make in China every year. While this might not necessarily show up in trade figures, it is still vital to think about this aspect as some of these profits will certainly be repatriated to the domestic economy for the benefit of shareholders. In a similar vein, the long-term implications for companies such as Apple or Qualcomm remain unclear. The Chinese domestic market not only makes up a significant proportion of their addressable market but is also a vital component of their supply chains. It is also not clear how an aggressive trade stance and walk away from negotiations could have positive implications for the US. Once a certain level of de-industrialisation occurs over decades, it is extremely hard if not downright impossible to re-calibrate supply chains. Think about the process of bringing back the factories necessary to fill the void that China would leave, even the know-how of old industries would take decades to redevelope. To misquote Tim Cook, ‘if you wanted to hold a meeting of all the machine tool workers in the United States you could do so in a single conference room and if you wanted to do so in China, you would require a football stadium.’
Similarly for China, they would find it exceptionally hard to walk away from the negotiations all together since they would lose access to their largest export market and, what remains to this day, one of their biggest sources of foreign direct investment (FDI). What seems more likely to us is that the nations will risk being boxed into a corner in the shorter term but find a resolution over the longer-run. In the short-run we find it increasingly likely that the White House will be incentivised to take an adversarial position in the run-up to the 2020 elections. What has been surprising for us has been the extent to which they have been willing to do so to this point (i.e. recent targets have included India and Mexico at the same time), perhaps Trump is fighting his war on too many fronts?
All that being said, the negotiations should also be contextualised within the changed circumstances of both countries and policies as well. The Chinese are also incentivised to be seemingly cooperative with their US counterparts in one respect, the reduction of surpluses in and of themselves. This is an existing trend already, in fact US services exports have been in surplus territory for quite some time and given that US exports to the Chinese market have been some of the fastest growing, speeding up this process is by no means as painful for the Chinese as one might think. One of the key aspects of the Belt and Road initiative is to take a controlled approach to the transfer of heavy industrial processes out of China, think of Chinese businesses making heavy investments in Vietnam in the same way GM did when China opened its doors to FDI as they seek to move up the value chain, and herein lies the big issue.
As China seeks to move up the value chain, they will increasingly compete with US businesses and commercial interests directly across the world. This is one issue that is not likely to go away any time soon. As they continue to expand their geopolitical influence from the South China Sea to Africa to Eurasia in order to protect:
These goals will mean that they will have to look to taking a multi-pronged and multilateral approach to both Global Trade and Foreign Policy. The US on the other hand has significant capacity to be unilateral in its approach and going by some of the rhetoric coming out of the White House, they might very well go back to the tenets of the Monroe Doctrine. For those of you unaware, the Monroe Doctrine was initially conceived of as a way to oppose European Colonialism and has been cited by Presidents as recently as Reagan, with changed contexts of course. This might mean that we go back to the days where the great powers, in this case China and the US, carve out ‘spheres of influence’ so to speak. In this context the US taking greater interest in South America and China carving out its own niches within Eurasia and the Asia Pacific region.
One key outcome under this latter scenario is rather than a beggar thy approach to trade as is most commonly feared, there will be a gradual disentanglement of supply chains on a regional basis with companies increasingly carving out niches based on geopolitical preferences. How this process evolves will be the key metric to assess the negotiating parties. In the short-to-medium term, an escalation of tensions will mean greater volatility for not only markets but currency and global growth too. China has been the central driver of global growth for the better part of two decades now and any downward trend here will be of particular concern to investors. Recent trends and rhetoric coming out of the upper echelons of the party could potentially mean that they are willing to tolerate pain in the short run though. Market volatility does not tend to contribute to the worries of officials in China given their reliance on credit markets which they can control tightly and expand at short notice. In addition, their ability to significantly expand fiscal expenditure given the sheer amount of government surpluses can also cushion out any significant corrections in underlying growth.
For the US, similarly, we think they will have to increasingly look towards initiatives to boost domestic growth via infrastructure spending. While many have made the comment that given the sheer amount of government debt this might not be a possibility, we think there is still room to expand here. As long as the US dollar remains the reserve currency (something we hope the ladies and gentlemen at the State Department keep in mind the next time they start throwing around unilateral sanctions), the US has the ability to finance its deficits with very little pain and at a discount to what would otherwise be the case. So, whatever the outcome of the 2020 elections and the vitriolic relationship between congress and the White House, there seems to be agreement that infrastructure spending will be a key priority going forward. We believe that from a markets perspective, this will create enough of a catalyst to overcome the pain to come as a result of longer term trade implications.
Opportunities for the discerning investor (The Australian Perspective)
Tying this all back to Australia, the implications are two fold. Firstly, our reliance on materials and energy exports mean that we will be extremely sensitive to even shorter term changes in global growth. Indeed, the recent contraction in the current account deficit is largely a result of higher than expected commodities prices and, going back even further to 2016, continued demand from China. Given the nature of our economy, the markets we remain sensitive to will continue to be the fastest growing energy consumers in the world, India and China. The White House's increasingly hardline stance with both of these nations does not bode well for us in the medium term as any slow down in their growth will have a disproportionate impact on our own economy. However, given our ability to be nimble both policy wise and economically (believe it or not), as the recent boost in aluminum exports (which we can thank the previous Turnbull government for) means that it isn’t all doom and gloom just yet. We remain a country that will be vital for US policy in Asia and China will remain, however reluctantly, a consistent and reliable customer for our exports. However, these two dynamics will have to be managed extremely effectively.
For one thing, as our title suggests, the US remains the source of the largest amount of FDI and China remains our largest trade partner. As such it will be crucial for Australia to manage both of these relationships effectively and somehow avoid being caught in the crossfire. Currency will also increasingly play a role for company profitability, especially those companies that are oriented towards growth into mainland China. It is increasingly likely that governments in China manage currency to the downside or alternatively use their over 1 trillion in US treasuries as a strategic tool. All this is to say that we see the AUD getting increasingly volatile both to the upside and downside, revenues/profits will follow in the same direction. This also has flow on implications for the broader underlying economy. A volatile currency and a commodities driven economy make monetary policy and capital investments harder to manage. One of the key issues that the RBA has largely ignored for now but will no doubt have to look at is the implication of shorter term fluctuations in the AUD for interest rate policy (which then has flowing implications for both housing and credit markets and the like).
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