Macro Battleship with Christopher Wood

The tweet may be a highly effective means for Donald Trump to manage the news cycle. But the methodology does not lead to coherent economic analysis. Tariffs are clearly bearish for the world economy and for world stock markets, even for the American stock market, though I will admit that China is much more vulnerable as the world’s biggest exporter exporting US$2.5 trillion of goods a year (see following chart). Indeed China accounts for 13% of world exports.

Annual Exports by Top Economies

Source: IMF – Direction of Trade Statistics (DOTS)

Even if the current negative consensus proves right, and there is no 11th hour U-turn by the Donald ahead of the G20 summit in Osaka on June 28-29, there remains, unfortunately, an even bigger long-term risk facing the world economy than the current trade war. That is the very negative implications of the current U.S. stance against Huawei, which is increasingly being labelled, not without exaggeration, as a tech war or a new cold war.

The origin of America’s ultra-aggressive stance, be it implemented via export controls or controls on inward direct investment, remains a determination that China will not dominate in 5G or other emerging technologies. This view began with the national security lobby and has become mainstream to the extent that there is now a bipartisan consensus in Washington that China poses a threat to U.S. hegemony.

Personally, I view this as nonsense. But that is beside the point. With China still so dependent on American tech components, Washington has the power to shut Chinese companies down, including Huawei with sales of Rmb721 billion (US$107 billion) last year. That is not only a threat to many American tech companies with large sales to China but also to other companies given that, in a typical U.S. example of jurisdiction overreach, the U.S. Commerce Department asserts that any product that has 25% of its “value” originating from America is a U.S. product. The result is that many tech companies are now wary of antagonizing Washington. Yet for many China is their biggest market.

With China still so dependent on American tech components, Washington has the power to shut Chinese companies down, including Huawei.

In this respect, the world has had much less historical experience of tech wars than trade wars but both should be viewed as bearish. Meanwhile, the U.S. attack on Huawei is at a minimum likely to slow materially the rollout of 5G. It also has increased Beijing’s incentive dramatically to upgrade its capacity in semiconductors to end reliance on the U.S., in what has now become a national emergency. This is feasible on a five- to ten-year view, if not on a one-year view.

Meanwhile, the best hope for the world economy, and the US-China relationship, must be that Wall Street sells off sharply ahead of the G20 Summit. Still, such a sell-off has now been made less likely by the reassurance offered by Jerome Powell in a speech on June 4 in Chicago that the Fed “will act as appropriate to sustain the expansion” if the trade situation deteriorates. The result is that money markets are now discounting 50bp of easing this year and another 25-50bp next year (see following chart), and belief in the so-called Fed “put” is stronger than ever among equity investors, in the sense that they believe the Fed will underwrite any significant stock market sell-off by cutting rates.

Fed Funds Futures Implied Rates

Fed funds futures implied rates - June 14 2019

Source: Bloomberg

The unfortunate consequence of this is that the Fed is enabling Trump’s aggressive stance on trade. Indeed I would go so far as to say that Trump has successfully bullied the Fed – just like he successfully bullied Saudi Arabia to increase oil production in the wake of the unfortunate Khashoggi affair last October. Meanwhile, if Donald Trump has always been a hawk on trade, I remain firmly of the view that he is not exercised by national security issues.

Trump is now much less “anti-China” than the anti-China bipartisan consensus in Washington. But the risk is, clearly, that he can be successfully manipulated by the national security lobby, as is suggested by the Trump administration’s continuing obsession with Iran.