It’s becoming clearer that the trade war could last quite a while. China has put further talks on hold, and administration officials are suggesting that the earliest possible resolution date will be in 2020. Investors may not have the luxury of standing on the sidelines hoping for a quick truce. That being the case, we may have to pick sides.
In order to determine who (or what) is going to win, consider the following question. Which is easier: to produce, or to consume? The answer may seem obvious, but not to the governments responsible for setting trade war policy. Obviously, consuming is easier than producing, which means, China being the bigger producer between the two countries given its trade surplus, the U.S. is at a considerable disadvantage. What China has to do to balance its own economy is allow domestic Chinese consumption to replace American consumption, whereas the U.S. would have to replace Chinese production with American production, something that is much harder to do, even arguably impossible. It’s not going to happen, so practically, it’s all up to China who wins.
True, replacing American demand with Chinese demand isn’t as easy as changing shipping addresses from U.S. importers to Chinese suppliers. Chinese exporters can’t simply sell all their products to domestic Chinese customers overnight, as the locals don’t have the purchasing power to replace American demand immediately. What would have to happen is China would have to stop lending the U.S. its own dollar surplus, and instead simply allow the value of the yuan to rise against the U.S. dollar by putting the brakes on its U.S. Treasury purchases.
So far, it doesn’t look like China is taking this route. Why wouldn’t they? Because a rising currency, though ultimately good for domestic consumers, requires a restructuring of the economy and labor markets. This generally is accompanied by recession, debt liquidation and temporary unrest. The yuan has depreciated 2.2% against the U.S. dollar since new tariffs took effect at the beginning of May. That effectively means that the 25% tariffs now in effect on some $200 billion in Chinese goods is down to about 22.8%, thanks to the 2.2% subsidy from yuan depreciation.
This decline in the yuan could be caused by a temporary kneejerk reaction from currency markets that will reverse itself, or it could be China intentionally weakening the yuan to cope with the new tariffs, or probably a combination. In order to determine if the move will reverse itself, keep an eye on Chinese foreign exchange reserves over the next few months. These are currently at $3.095 trillion, per the latest data from April, before the new tariffs were applied. If upcoming data for May shows a significant drop, then perhaps China will reverse the yuan’s slide against the dollar. Continue down that course, and China will eventually win the trade war, as much as one could be won anyway. If forex reserves keep rising though and the yuan keeps falling in China's attempt to stimulate its economy, Trump’s tariffs will be subsidized by China and the U.S. would “win.”
Most likely though, neither country will end up winning, and China’s central bank will do what it can to keep the dollar-yuan exchange rate pegged so as not to rock the boat too much. This would cause consumer prices to trend higher in both countries, the “winners” being real assets and those who own them. Given the behaviors of central banks generally since the financial crisis over a decade ago, this will probably be the ultimate outcome. Call it a race to the bottom, competitive devaluation, or a mutual economic suicide pact, we are most likely going to see what we’ve seen for years – slow, steady, creeping consumer prices generally.
The only difference now is that it’ll be at a faster pace.
Disclosure: No positions.
