U.S.-China trade war uncertainty continues to weigh on global growth, dampening business confidence and stoking fears of a recession. Haining Zha, vice president, TD Asset Management dives into how the trade war is impacting China and the U.S., and what that could mean for investors.
- Haining, we've seen a dramatic escalation in the trade tensions between US and China over the last couple of weeks. What do all these moves between the US and China mean, and what impact could that have on the global economy and markets going forward?
- I think the market is feeling quite nervous about the recent escalation of trade war. We agree it is a clear negative, but we think the actual impact is actually more manageable than what markets feared. I think before we do the number crunching, it is important to clarify some misconceptions. When we mention the headline trade data, for example the $500 billion US imports from China, or $400 billion US trade deficit against China, the numbers are actually calculating the gross value of the goods.
That's all fine if we are in ancient times, then, when there is very little international cooperation and all of the productions are done domestically. But that's no longer the case. In a world where the global supply chain are fully integrated, I think it's important to look at the value-add break down from different countries to measure the true economic impact.
One prime example is the Apple iPhone. For example, the iPhone X is sold at the price of $1,000. And let's have a breakdown of that particular product.
Out of that $1,000, about $650 are the Apple's gross profit margin. And then only $350 are the actual production cost. And within that $350, only less than 5% are actually the value add from China. But in the headline trade stats, actually all $350 are categorized as China's export to the US. So if 10% tariff is imposed onto the Apple's products, as you can imagine it will actually hurt other countries more than China's.
- Because a lot of value-add is coming from other countries, as opposed to just China.
- Exactly. For example, out of that $350, a lot of components are coming from Korea, Taiwan, or even the US.
- You mentioned that the 10% tariffs will impact other countries other than China. Is that the case for the last round of tariffs?
- That's exactly the case. So according to the IMF's data, in the previous round of tariff hike, almost all of the tariff costs are passed down to the US consumers.
- And it was not being absorbed by China, as some were stating?
- That's not what the data says. And don't forget, in the previous tranche of $200 billion worth of goods, these $200 billion goods were very carefully calibrated by the US government to avoid impact on US consumers.
- We've seen, certainly, China's currency weaken against the US. Do you see this trade war evolving into a currency war? Is there a risk? And what impact could that have on the global economy?
- We don't see a full scale currency war. But we do believe that in the next episode of trade escalation the currency will be used as a tool to moderate the impact on the global market and global economy.
- And staying with currency, this is also the first time that China has been labeled a currency manipulator by the US. Now, other than calling China out, are there any actual tangible consequences to this?
- Actually, not a whole lot. Because according to the US law, once a particular country is designated as currency manipulator, one of several things can happen. Number one, the US government can restrict private investment into that country, and number two, the US can restrict the government procurement, and number three, US can basically impose more tariff.
So basically two and three are already happening. And we don't see the first option is doable, because--
- Why is that?
- --it will be quite damaging for the US multinational corporations. It basically shuts the companies out of one of the largest consumer markets in the world.
- And what's been the impact of the trade war on investment?
- So, so far from the market peak, S&P dropped 5-6%. We agree that the market is due for a bit of correction, but we are not that pessimistic. And there is some speculation in the market that there could be another trade war version, a Lehman-like meltdown.
- Why is that?
- Well, we don't believe that's the case because of the reason I mentioned that the trade war impact is actually more manageable. And on top of that, when this negative development happens, it actually forces the central bank to do more easing to achieve their mandate.
- And when you say "manageable," is that manageable by the US, or China, or both?
- I think it's a little bit both. So first of all, as we mentioned before, most of the costs are likely to pass on to US consumers or absorbed by the US companies. So if it's passed on to the US consumer, 10% on $300 billion of goods, that's $30 billion extra costs. $30 billion extra costs, when divided by the total household consumption, which is around $14 trillion--
- It's a drop in the bucket almost.
- --yeah, that's basically about 20 basis points impact. And if some of them are absorbed by the US companies-- for example, S&P 500 companies-- their annual earning is about $1.4 trillion dollars. So that's about 2% impact. Its $30 billion cost is about 2% impact.
And don't forget, we mentioned that FX can be used as a tool to manage that impact.
- The foreign exchange, yes.
- Yeah. So all in all, for sure it's a negative. But we think so far the impact will be more manageable.
- So given all that, where do you see the trade war going forward?
- Actually, going forward-- because the new round of tariff will take effect in September. And after that there will be probably a two to three months observation period, and various parties will observe how people react, how the economy fares under the new tariff. And afterwards, one easy option for President Trump would be increase the tariff rate from 10% to 25%.
At that point, basically 25% tariff will apply to all Chinese imports. And then afterwards, there will probably be another observation period, and then we'll get into the US election season. And from there, I believe the road map will be a little bit unclear. But I believe the motivation for negotiation on China's side will probably drop a little bit.
- And why's that?
- Because, essentially, you are not sure if you are negotiating with the right people. And if any terms are reached, whether the new government-- if there is a new government-- will honor that previous agreement.
- That agreement. And finally, what are the market risks and opportunities investors should be watching for in terms of the trade war going forward?
- Actually, at this point we see more opportunity than risk.
- Why is that?
- The only thing is the price hasn't dropped enough. Because before this episode, the year to date S&P 500 return is actually more than 20%. And then from the peak it dropped only 5-6%. And if you look at it on a valuation basis, the US equity is still, compared to historical average, relatively more expensive. So we will just be patient and looking to getting exposure when we are at a good entry point.
- Haining, thank you very much for your time.
- Thanks for having me.