How will Sino-U.S. relations unfold? That’s the question of the hour and the answer will likely define the next leg up (or down) in the global equity markets. Having asked China to reduce its bilateral trade deficit with the U.S. by $200 billion to no avail, the Trump Administration has placed tariffs on $250 billion of imports from China and threatened to impose an additional $256 billion to bend the will of Beijing. China has retaliated by placing tariffs on U.S. imports of $110 billion. But with U.S. imports in 2017 totaling just $130 billion, the import imbalance is such that the U.S. has 4x more fire-power in the tariff dispute. China’s asymmetric disadvantage in the tariff ‘tit-for-tat’ means that any measured response will require Beijing to resort to actions that will dramatically escalate the dispute. As a result, we are at a cross-road and the uncertainty regarding ‘what happens next’ has put downward pressure on the global equity markets.
Amid the confusion, we continue to expect a multilateral agreement by year-end that will lift Sino-U.S. tariffs altogether. The negotiated settlement could be (i) a simple bilateral trade deal, with China pledging to increase imports, or it could (ii) be modeled after the Plaza Accord and include a structured appreciation of the renminbi (RMB) against the U.S. dollar (USD). We believe President Trump has been pursuing the latter path – what we have dubbed the ‘Waldorf Accord’ – but suspect the White House will, ultimately, settle for the former. Our assessment stands juxtaposed with the Wall Street consensus, which remains focused on the opposite outcome, namely a competitive devaluation of the RMB. For example, the baseline forecast from Deutsche Bank is for the USD/RMB to strengthen from 6.92 today to 7.4 in 2019. We believe there is (at least) an equal probability the USD/RMB exchange rate moves the same amount in the opposite direction, for the reasons outlined below. We attribute the difference of opinion to a general misunderstanding of the ‘Trump Ask’ and, in turn, the willingness of Beijing to accept it. From our vantage, there is a ‘free-option’ in the equities of U.S. and E.U. companies exporting to China, where trade resolution would drive +30% gains, if share prices return to their 52-week highs, while downside is mitigated by share buyback programs and dividend yields higher than U.S. Treasuries.
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Trump Agenda Parallels Reagan Administration. We believe the trade policies of President Trump are best understood, when set alongside the agenda of the Reagan Administration, which enacted tax legislation in 1981, before imposing import tariffs on Japan in 1984 to compel Tokyo officials to reduce its U.S. bilateral trade deficit. The sequence of events should sound familiar. We can only assume that Trump is ‘ripping-a-page’ out of the playbook of the Reagan Administration, which achieved a trade balance reduction in September 1985 with the Plaza Accord, an agreement between the U.S., Japan, U.K., France, and West Germany (the G5) to devalue the USD against the other major currencies. In contrast to most currency devaluations, the Plaza Accord was engineered by the G5 central banks that, together, injected $10 billion between 1985 and 1987 to, principally, force a 40% decline in the USD/JPY, which reversed the 44% movement in the prior 5-years. For the U.S., the Plaza Accord proved to be a highly effective policy tool: between 1987 and 1991, the bilateral trade deficit between the U.S. and Japan declined from $152 billion to $30 billion, a staggering 80% reduction.
Exhibit 1: New Tariffs vs. Sino-U.S. Imports
Plaza Accord as Precedent. The success of the Plaza Accord, albeit with a two-year lag, not only makes it a useful precedent for understanding Sino-U.S. relations today, but also the likely end-goal of President Trump, who is faced with challenges similar to the ones that confronted the Reagan Administration, which pursued a devaluation of the USD to tackle the ‘twin deficits’ formed by (i) the increase in the federal deficit, as a result of the 1981 tax legislation, and (ii) a record trade deficit of $122 billion (or 3.5% of GDP) in 1985 that was being compounded by the rising interest rate path of the U.S. Federal Reserve under then-Chairman Paul Volcker.[1] To execute his trade agenda, President Trump has notably hired key veterans of the Reagan Administration, including Robert Lighthizer and Larry Kudlow. Having led U.S. negotiations in the 1980s with Japan as Deputy Trade Chief, Lighthizer is now using the same WTO provisions (in section 301) to justify tariffs against China.[2] Kudlow, who served under David Stockman in the Office of Budget Management has made his views on tariffs abundantly clear. “I’m not a tariff guy,” Kudlow told reporters in April. “But sometimes you have to use tariffs to bring countries to their senses.”
Reinterpreting the ‘Trump Ask.’ If we accept the Plaza Accord as precedent, it is possible to make sense of the White House request for a ‘$200 billion reduction,’ which has largely confused economists that are quick to cite that current account surpluses are a simple matter of arithmetic, measuring the gap between domestic savings and investment. For example, the International Monetary Fund (IMF) has recommended the U.S. reduce the trade deficit by increasing the household savings rate. This recommendation makes sense – the trade gap might disappear altogether if the U.S. household savings rate of 2% were to approach the 47% figure in China – but the notion is as palpable today as it was in 1985 to President Reagan, who opted to solve the problem through a coordinated devaluation of the USD; an unorthodox approach that falls outside of the scope of IMF models that assume fixed exchange rates. When the same logic is applied to the present, Trump’s ‘$200 billion’ headline demand needs to be redefined as a request for a devaluation of the USD/RMB exchange rate. The nuance in language is necessary because the U.S. Treasury has never stepped-away from a ‘strong dollar’ policy, to protect the reserve currency status of the USD. The notion is also supported by remarks from U.S. Treasury Secretary, Steven Mnuchin, who told CNBC on October 12: “We’re going to make sure currency is definitely part of these discussions.” Mnuchin said he had had “constructive” discussions with Yi Gang, the governor of the People’s Bank of China (PBOC), at World Bank and IMF meetings in Indonesia, where “the weakness in the currency” and the possibility of a “competitive devaluation” were discussed.
Multilateral Grand Bargain Required. But, if China is the principal target, why is the Trump Administration also placing tariffs on the E.U. and other western allies? Once again, this is a riddle that can only be understood, when viewed through the prism of the Reagan Administration, which levied tariffs against West Germany in advance of the Plaza Accord that required multilateral participation. Given the stand-off in the Sino-U.S. debate today, we suspect Trump has imposed tariffs on western allies to force them into a process that, ordinarily, would have been avoided. After all, if someone told you there was a gunfight in the room next door, your instinct would not be to enter the room to broker a deal. That would likely only happen, if a gun was pointed at you or someone you love, right? Trump’s use of the WTO is also consistent with steps taken by the Reagan Administration, which leveraged the multinational forum and mutual points of agreement on market access and IP theft to pressure reforms on Japan, so the policy ideas and sequence of events today are not new. As best as we can tell, the process is moving according to plan, given that E.U. and Canadian officials are reportedly already working on a draft proposal for the WTO. The last piece of the puzzle is whether Beijing will agree.
Beijing Open to Currency Appreciation. Will Beijing accept the ‘Trump Ask?’ Assuming certain conditions, we are confident the answer is yes. While the PBOC has firmly stated, “we will not pursue competitive currency devaluation and will not use the currency as a weapon,” no official has ever resisted the idea of a stronger RMB; an important distinction in a culture, where diplomatic omissions are equally weighted with admissions. When President Trump told Reuters, on August 20, that “China’s manipulating their currency, absolutely,” the official PBOC response was: “the two sides should communicate the issue.” But, if a stronger RMB will hurt export growth, why would Beijing accept it? The simple answer is that China’s long-term objectives (more below) can only be achieved, if the RMB strengthens against the USD, so Beijing officials have good reason to accept some near-term discomfort, if priorities can be achieved with the stroke of a pen. What’s also clear is that Beijing does not want to repeat the mistake of August 2015, when a poorly-telegraphed depreciation of the RMB prompted speculators to pile in bets against its currency that, ultimately, required the PBOC to spend half a trillion of its foreign currency (FX) reserves that now total $3.1 trillion.
Beijing’s Parameters for a ‘Waldorf Accord.’ What Beijing does not want to do is commit its FX reserves to force a depreciation of the USD/RMB. The PBOC reaffirmed this point in a statement to the IMF on October 13, saying, “China will continue to let the market play a decisive role in the formation of the RMB exchange rate,” and, “will not engage in competitive devaluation and will not use the exchange rate as a tool to deal with trade frictions,” adding “we expect the IMF to play a greater role.” Taken together, these points imply the ‘bone of contention’ is not whether the PBOC will accept a stronger currency, but, rather, who will fund it. That suggests the possibility of a multilateral agreement, a ‘Waldorf Accord,’ that includes a structured USD/RMB depreciation. It could either take the form of (i) the Plaza Accord, with central banks directly purchasing RMB assets, or (ii) be conducted through the special drawing rights (SDR) unit of the IMF, which voted to add the RMB in November 2015 at an 11% weighting alongside the USD (42%), Euro (31%), JPY (8%), and British Pound (8%). The Trump Administration can pursue either alternative, without the consent of Congress or the U.S. Federal Reserve, using the Exchange Stabilization Fund of the U.S. Treasury that has $95 billion of assets, including USD of $22 billion and SDRs of $51 billion.
IMF-Sponsored ‘Waldorf Accord’. We suspect Beijing officials prefer the SDR unit, which was first-introduced by the IMF in 1969 and largely forgotten until Zhou Xiaochuan, former PBOC Governor, suggested in March 2009 that it be adopted as a reserve currency. For example, were the RMB weighting in the SDR unit doubled from 11% to 22%, IMF members would be required to purchase ~$250 billion of RMB assets over 5-years.[3] RMB purchases would be measured and coordinated with the PBOC that, in turn, has the capacity to let the RMB strengthen +25% against the USD in the period. The process is quite simple. If IMF members purchased RMB assets of $250 billion, the Chinese currency would increase from 1.4% to 4% of total central bank FX reserves. By comparison, the GBP and JPY both represent ~5%, so the capital flows will put China on a more equal footing within the IMF ranks; an important distinction for Beijing officials, who will need to control the narrative domestically, where any comparison between China and Japan in 1985 will be poorly received.
Exhibit 2: Illustrative Waldorf Accord
Beijing’s International Objectives in Brief. If you are still unconvinced Beijing will accept a stronger RMB, just consider the following question. If you knew the USD/RMB exchange rate was going to depreciate by +25% in the next 5 years, would you purchase Chinese bonds that have yields higher than U.S. equivalents? Only a fool would answer in the negative. Your answer is important too, because (i) attracting passive, outside capital into China’s bond market is a key priority of Beijing officials, who first-opened the world’s second largest bond market in 2015 to foreigners that hold just 2% today. In response, we would also expect China’s bonds to be rapidly added to the three largest global bond indices that are currently reviewing their inclusion; a process UBS estimates will drive $350 billion of foreign inflows. It’s important to recognize here that Beijing officials are in unchartered waters today. For the first-time in the Middle Kingdom’s ‘5,000 years of continuous history,’ China’s long-term objectives require foreign consent. This is a new phenomenon with profound implications on the future geopolitical landscape. With exports having fallen from 35% of GDP in 2007 to 19% last year, Beijing’s core objectives also include (ii) transitioning China’s economy from being export-driven to one that is consumer led, a shift that would be helped by a strong RMB that would allow consumers to purchase cheap imports; (iii) “internationalizing” the RMB, which the PBOC plans to make freely-convertible by 2020, so that China can pay for imports (e.g., oil, gas) with fiat currency, instead of USD; and (iv) reducing corporate leverage, much of which is USD-denominated. A structured depreciation of the USD/RMB exchange rate would facilitate the above goals, while also providing (v) the PBOC with a reason to decouple from the forward interest rate path of the U.S. Federal Reserve and (vi) the Communist Party with a justification for any future growth slow-down. What’s not to like?
Trump deploying Kissinger’s “Mad-Man" Strategy. Of course, the big difference between Trump and Reagan, the ‘Great Communicator,’ is approach. From our vantage, Trump’s seemingly erratic and unpredictable approach better resembles Henry Kissinger’s “mad-man” strategy that was conceived within the context of Cold War diplomacy, where nuclear détente had led to a stalemate in Soviet-U.S. discussions. To quote Kissinger: “A mad-man, who is holding a hand-grenade in his hand has a very great bargaining advantage.” With nuclear weapons in place, Kissinger reasoned: “The only way one can communicate one’s determination I think is by conducting a policy in which one indicates a high capacity for irrationality. What one has to do is to prove in certain situations one is likely to go out of control and that regardless of what sober calculation would show one is simply so nervous that the gun is going to go off.” Sound familiar? Kissinger has met with Trump on several occasions, so the link is not out-of-the-question. The key take-away here is that Trump appears to be deploying the same “mad-man” strategy that Kissinger counseled Nixon against. After citing the example of Nicolai Khrushchev, who famously banged his shoe on the table at the United Nations in 1960, Kissinger told Nixon: “Given the public opinion of Western Democracy this is not a policy that can be conducted.” Today, we are seeing a role reversal. With the U.S. having ceded the moral high ground, we suspect President Xi will follow the path of Chairman Mao, who, “as a strategist,” Kissinger said, “recognized the need for priorities even at the temporary sacrifice of some of China’s historic goals.” Meanwhile, Kissinger has made one public statement on Trump, telling the Financial Times: “I think Trump may be one of those figures in history who appears from time to time to mark the end of an era and to force it to give up its old pretense. It doesn’t necessarily mean that he knows this, or that he is considering any great alternative. It could just be an accident.”
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Our intent here is not to offer a policy prescription. We do not believe events will transpire exactly as we have described and think the Trump Administration should backtrack from a structured depreciation of the USD/RMB. To borrow from President Dwight Eisenhower: “In preparing for battle I have always found that plans are useless, but planning is indispensable.” What’s important here is the likelihood of trade resolution. And, if we can develop a suitable framework that gives each party what they need, then surely policymakers with better access to information can arrive at a more satisfactory agreement. That suggests to us the probability is high. What’s more, policymakers will look to historical precedents, so we can expect the forthcoming agreement to be a derivate of something we have already seen.
When we consider the possibility of a ‘Waldorf Accord,’ the one obvious ‘known unknown’ is that RMB gains will come at the expense of the USD, which represents 90% of global transactions in the $5.1 trillion foreign-exchange market and 2/3 of the $11.4 trillion in foreign-exchange reserves. Our concern is that a ‘Waldorf Accord’ would reduce the U.S. trade deficit, by making it more expensive to fund the fiscal deficit that depends on the participation of foreign investors, who will demand higher yields, if easier gains can be made in RMB bonds. We also fear the Trump Administration is underestimating Beijing’s resolve to internationalize the RMB, particularly in the oil/gas market, where an RMB-denominated crude oil benchmark was launched in March.[4] With the RMB already used for oil purchases from Russia and Iran, one must assume Beijing will act like any other ‘economic animal’ and make a best-effort attempt to extend the policy to other oil producers, who will view the RMB more favorably, if it’s strengthening against the USD with broad international support. After all, Beijing is in a position to make the same convincing argument that U.S. businessmen made to oil producers in the Middle East (then used to GBP) in the 1950s, namely, ‘we are your biggest customer and the largest lender to the government that prints the fiat currency that you accept for payment, so why not take our currency instead?’[5]
Having taken two-steps forward, the Trump Administration may also come to better understand the potential consequences of a ‘Waldorf Accord’ and take one step back, settling, instead, for a simple bilateral agreement, with China agreeing to increase U.S. imports by an amount greater than its earlier $70 billion offer that was rejected in April by the White House. A bilateral deal does not have the capacity to dramatically alter the trade deficit, but it will improve trade terms, while also preserving the integrity of the USD, so it is the preferred path, in our view. The benefits of hindsight suggest the optimal timing for a ‘Waldorf Accord’ was more than decade ago, in 2005, when Ben Bernanke, then a vice-chairman of the Federal Reserve, first-identified the foreign “savings glut” that is now commonly understood to be the source of the 2008 Financial Crisis. China’s FX reserves, which totaled $1 trillion in 2005, have since risen to $3.1 trillion.
The ‘silver lining’ here is that any form of trade resolution will cause the global equity markets to rise precipitously, in the short-term. To give some idea of the possible upside, consider that the S&P 500 is trading at 15.8x forward earnings, a figure that has contracted from 17.8x in the three-months before trade tensions surfaced in late February. Were the former to increase to the latter level, in response to a trade deal, the S&P 500 index would rise +12% above 3,000 points. The equities of U.S. and E.U. companies that export into China will rise even higher, in our view. To that end, we have invested in the below equities (see Exhibit 3) that, on average, will return 33%, if share prices return to their 52-week highs. The downside is also mitigated by large share buyback programs and dividend yields that equate with U.S. Treasuries. From our vantage, these equities offer a free option on trade resolution, irrespective of whether the prospective agreement includes an RMB appreciation. We also like the hedging characteristics of gold that stands to benefit if the USD weakens or trade negotiations deteriorate.
Exhibit 3: Mast-Head Investments (November 1, 2018)
If the Plaza Accord is a precedent, as we suspect, history suggests an international agreement will materialize during the next couple of months. After all, it took six-months for the G5 to process the Plaza Accord in 1985, at a time when the Soviet threat compelled Western allies to cooperate, so one would expect current negotiations to last several months longer.[6] To that end, we suspect Beijing will maintain a tough-stance through the U.S. mid-term elections that will reduce President Trump’s bargaining position, if the Republican Party loses the House of Representatives as early polls suggest. But, with the G20 Summit set for November 30 in Buenos Aires, all parties have a strong incentive to strike a deal. Plus, any agreement will be welcomed in each leader’s home country, where the capital markets can be expected to rise sharply higher into the New Year. By contrast, if the holding-pattern persists, multinational companies will have no choice but to alter their corporate plans in 2019, leading to an investment slow-down with the capacity to trigger a broader economic recession. Let’s also remember the current situation is untenable for the E.U., where automakers have been faced with export tariffs of 40%, so we have a hostage negotiator in the room actively trying to broker a deal.
In the meantime, we can only offer a prayer attributed to U.S. naval chaplain, Howell Forgy, that has given strength to better individuals in greater turmoil. “Praise the Lord and pass the ammunition.”
[1] In the short-run, currency depreciation worsens the trade balance because the rising price of imports outweighs the fall in import quantity or rise in export quantity. Those effects dissipate over time, causing a ‘J-Curve’ pattern.
[2] For color, Lighthizer earned the nickname “the missile man” in Tokyo, after he turned a Japanese proposal into a paper airplane and floated it back across the table at negotiators.
[3] The SDR weighting is reviewed by the IMF every 5-years.
[4] Crude oil futures on the Shanghai International Energy Exchange rose by a factor of 4.3x (from 623k barrels to 2.7 million barrels) in the six-months ending September, according to research data from CLSA.
[5] In the 1950s the GBP area, incl. 35 countries pegged to the GBP with FX holding primarily in GBP, accounted for half of world trade and GBP accounted for over half of world foreign exchange reserves. In 2015, nearly 60% of countries, representing 76% of global GDP, had exchange-rate regimes anchored in some way to the USD in 2015.
[6] In April 1985, Secretary of the Treasury, James Baker announced the U.S. was “prepared to consider the possible value of hosting a high-level meeting of the major industrial countries.” The Plaza Accord was signed on September 22, 1985.