Back on May 19, Steve Mnuchin managed to secure what was briefly billed as a “truce” with China on trade.
Given the myriad escalations and contentious rhetoric that have defined the trade narrative in the two months since, it’s easy to forget that after meeting with Chinese Vice Premier Liu He in Washington on Friday, May 18, the White House released the following statement the next day:
On the heels of that, Mnuchin made the Sunday talk show rounds, telling Fox News that for the time being, the trade war was “on hold“.
That fleeting moment of sanity came at a time when notorious China hawk (and man who thinks America’s farmers are “rounding errors“) Peter Navarro was still stuck in adult timeout, after being briefly sidelined from negotiations following a profanity-laced shouting match with Mnuchin in Beijing.
In the days following Mnuchin’s infamous “on hold” comment, the protectionist contingent struck back, with a little assist from Steve Bannon, who told Bloomberg the following about the Treasury Secretary’s attempts to make nice with Beijing:
They’re in a trade war with us and it hasn’t stopped. Mnuchin has completely misread the geopolitical, military, and historical precedence and what President Trump had done was finally put the Chinese on their back heels.
You can “credit” Bannon (at least in part), with reigniting the protectionist fire and prompting Trump’s subsequent about-face, which not only involved the President announcing a D-day for the imposition of tariffs on the first round of Chinese goods in connection with the 301 probe, but also the White House refusing to grant further waiver extensions to America’s allies on the metals duties.
The rest, as they say, is history (or maybe “drunk history” is a more apt description of the ongoing effort to roll the clock back on decades of progress).
One thing that’s become clear over the past two months is that China has more in the way of flexibility when it comes to fighting this battle than the U.S. Trump’s broadside on Jerome Powell’s Fed and subsequent tweets about the monetary policy divergence between the U.S. and its trade partners amounted to an admission that the Chinese have been quite adept when it comes to offsetting the impact of the tariffs by countenancing yuan depreciation.
Indeed, both Goldman and Deutsche Bank have suggested that China effectively negated the impact of the first two rounds of tariffs before they’ve even been implemented. There’s an in-depth discussion of how the PBoC has gone about pushing the policy divergence with the U.S. wider while maintaining plausible deniability when it comes to accusations of “manipulation” here: “Chinese Yuan Slump Zeros Out First Two Rounds Of Trump Tariffs: By The Numbers“.
Having thus largely achieved the desired end with the currency, the next logical step for China was to try and reinvigorate the country’s struggling stock market. The Shanghai Composite of course fell into a bear market earlier this year and monetary easing has been largely ineffective when it comes to shoring up sentiment. The U.S./China equity ratio is still hovering near its lowest in a dozen years.
Well, guess what China did? They announced fiscal stimulus measures following a meeting of the State Council in Beijing, last week, that’s what they did. The details of that are available here, but suffice to say the message was more important than the specifics. Fiscal policy, Beijing said, will be “more proactive” going forward.
Following that announcement, the iShares MSCI Emerging Markets ETF outperformed the iShares Russell 2000 ETF by the most since February of 2016.
For Trump, the read-through is simple: this trade war is going to be anything but “easy to win”. China is taking a two-pronged approach to shielding the economy that involves both fiscal stimulus and monetary easing, with the former aimed at supporting overall sentiment and the latter designed to keep liquidity flowing and manage the yuan in a way that keeps the currency weak enough to buoy exports, but prevents the type of runaway depreciation that catalyzed capital flight in 2015.
Inherent in that description is the notion that while China has done an admirable job over the last couple of years managing what amounts to an impossible trilemma, the trade frictions have undoubtedly made things harder. Without fiscal stimulus, it’s possible that the situation will become completely untenable.
“Industrial production growth slowed significantly in Q2 [thanks to] a notable slowdown in exports and the drag from fiscal policy, reflecting the marked decrease in support from on-budget spending, the continued weakness in shadow banking, the sharp decline in LGFV bond issuance and the slow issuance of new local government bonds”, Goldman wrote, in a note dated Sunday, before explaining why fiscal stimulus is necessary for China at this juncture.
If these factors continue developing in this way, the growth target – which is still a government priority – could be jeopardized, and we could see a looming stability dilemma (Exhibit 2). Under these circumstances, we believe the more flexible stance in the latest shadow banking rules reflects a compromise to some extent. Given our expectation of continued modest export momentum, the potentially diminished efficacy of monetary policy (e.g., due to capital constraint) and the current tightening bias of financial regulation, we believe a supportive fiscal policy is required to maintain growth stability, particularly in the absence of a significant retreat in financial regulations.
But again, China is used to walking a policy tightrope. They’ve effectively been trying to releverage and deleverage at the same time since 2015, while simultaneously managing the currency and convincing the world of their seriousness when it comes to opening up domestic capital markets. It’s a tedious balance, but they’ve got the tools to do it. Trump, on the other hand, is more constrained.
In his latest note, out on Monday, JPMorgan’s Marko Kolanovic spends a bit of time discussing all of this. After explaining why he believes a rally for small caps and emerging market equities might be in the cards, Kolanovic notes that “when it comes to forecasting the outcome of the trade war, one should keep in mind that Trump can ratchet up tariffs without Congress, but his ability to employ additional fiscal measures and impact monetary policy is likely lower than that of China.”
Just hours after Marko’s note started making the rounds, The New York Times reported that the Treasury is considering bypassing Congress on the way to using executive authority to grant an additional tax cut to the wealthy. That speaks to the fact that although the President was able to cram through a historic tax overhaul, his ability to go further is constrained by the legislative process. The calculus there is likely to get more complicated after the midterms in the event Democrats manage to gain ground.
When it comes to tariffs, some Republicans have recently suggested that in the event the White House continues to push the envelope, Congress will introduce legislation to limit Trump’s authority to make unilateral decisions on trade. Here’s what Orrin Hatch (a Trump supporter, by the way), said on the Senate floor earlier this month:
If the administration continues forward with its misguided and reckless reliance on tariffs, I will work to advance trade legislation to curtail presidential trade authority. I am discussing legislative options with colleagues both on and off the Finance Committee and I will continue to do so.
Additionally, it’s important to note that while Trump is apparently going to attempt to influence Fed policy, the very act of making his desire to do so public constrains Jerome Powell’s ability to lean dovish (i.e., it puts the Fed in a position where any pause in the hiking cycle could be criticized as an effort to appease the White House).
Kolanovic goes on to posit the following about where the trade dispute with China goes next, in light of everything said above. Here are the relevant excerpts:
This doesn’t mean that the US administration cannot avoid a disruptive trade war and claim a quick win. We have argued since March that this will be the most likely outcome. The complex issue of global trade can be (inaccurately) simplified to the issue of the balance of trade in goods. Going further, the administration may view this trade war as a negotiation of a real estate deal. In that context the US ‘ask’ was a $200bn change in trade balance, and it was reported that China was ready to purchase an additional $70bn of US goods. This was considered too low to be ‘countered.’ Currently Trump is waiting for a higher bid and adding pressure. The new offer could be, for example, ~$100bn, countered with ~$120-$150bn for the final deal. The most recent agreement with Europe puts additional (but more subtle) pressure on China and hence increases the probability of a resolution, in our view.
Fast forward to Tuesday morning and Bloomberg reported that Mnuchin is set to negotiate one-on-one with Chinese Vice Premier Liu He, with whom he struck the short-lived deal mentioned here at the outset.
According to Bloomberg’s sources, there’s no “specific timetable [and] the issues to be discussed and the format for talks aren’t finalized.”
But where there’s a will, there’s a way (as it were), and despite the lack of actual planning, “there is agreement among the principals that more discussions need to take place”, Bloomberg says, citing the same anonymous officials.
What does all of this mean? Well, it means that the Trump administration probably can’t “win” this. “Unless Trump can engineer a meaningfully weaker USD, a proper trade war with China would be difficult to win”, Kolanovic notes, correctly.
So Trump will need to play for optics here. Time is running short, though. The tariffs risk eroding Trump’s support in the farm belt and the move to lean on a Depression-era subsidy program on the way to bailing out U.S. agriculture was not well received. China, meanwhile, has already offset the tariffs with currency depreciation and is not constrained when it comes to loosening up fiscal policy. In other words, they can ride this out, whereas the clock is ticking under 100 days to the midterms for Trump and the GOP.
If Republicans do manage to hold serve in the midterms even as the trade war rages on, the longer-term outlook is questionable, at best.
“If the trade war strategy does not lead to incremental growth, it will hit the economy hard once the fiscal boost wears off”, Kolanovic goes on to write, adding that while effectively sacrificing “stashed away” market gains to play for time might work for a few months, “the trade war increased the tail risk of miscalculation that can be compounded with the backdrop of the Fed underestimating the tail risks coming from financial markets (e.g., the impact of rate hikes on liquidity and leverage).”
In the final analysis, the clock is ticking on this for the Trump administration, and that may account for news that suggests Mnuchin is being put back in charge of leading negotiations.