Who’s Really ‘Winning’ The Trade War? The Truth Behind The Rhetoric

Over the past two months, the battle lines have been drawn in the escalating global trade conflict and Donald Trump likes to pitch himself as a kind of male Wonder Woman, taking fire so that the beleaguered American worker can finally gain the upper hand in the battle to reclaim lost industrial “greatness”.

But the shrill protestations of Larry Kudlow, Wilbur Ross and Trump himself notwithstanding, China is not “losing”. To the contrary, China appears to be “winning”, or at the very least, holding serve.

On the heels of the second quarter GDP release, Trump and his advisors embarked on a concerted effort to pitch the data as evidence that the U.S. economy isn’t suffering from the trade frictions. Trump went so far as to convene a press conference at the White House to tout the data, calling it “amazing”. A week later, Kudlow made a series of inflammatory remarks about the Chinese economy on Bloomberg Television.

“Some of the currency fall I think is just money leaving China because it’s a lousy investment, and if that continues that will really damage the Chinese economy”, Kudlow said of the yuan’s rapid depreciation against the dollar. “If money leaves China – and the currency could be a leading indicator – they’re going to be in a heap of trouble”, he continued, before driving the point home by contending that Beijing is “in a weak economic position that’s not a good place for them to be vis-a-vis the trade negotiations.”

All of that is propaganda – full stop. The U.S. economy is indeed doing well, but that’s likely a sugar high (so to speak) that’s destined to wear off as the fleeting effects of late-cycle stimulus fade. Even if you give Trump and Kudlow the benefit of the doubt and assume the current rate of expansion is sustainable (i.e., if you assume one can extrapolate something from the quarterly numbers), it’s still not anomalous from a historical perspective, so pitching what we’re currently seeing in the U.S. as some kind of economic renaissance is disingenuous.

Additionally, it’s important to understand why Trump and Kudlow were pounding the table so hard last month. The effects of the trade war are indeed hitting home, figuratively and literally. On July 24, just three days before Trump’s GDP press conference, the government announced a $12 billion rescue package for farmers suffering from the tariffs. That bailout entailed dusting off Depression-era policies to subsidize American agriculture. The absurdity inherent in the effort was readily apparent both to lawmakers and to farmers themselves: Trump instituted trade policies that posed an existential threat to American agriculture and then, facing a severe backlash, decided to bail them out with their own taxpayer dollars. In the final insult, Trump peddled $45 “Make Farmers Great Again” hats on his website and, in a testament to the sad gullibility of the farm belt, they sold out within hours.

On the corporate front, General Motors, Harley-Davidson and Whirlpool all explicitly cited the tariffs on the way to explaining either earnings misses, guidance cuts or in some cases both last month and two Mondays ago, Caterpillar said it will likely be forced to raise prices to compensate for as much as $200 million in tariff-related costs. For its part, Tyson Foods slashed guidance citing “changing global trade policies [at home] and abroad and the uncertainty of any resolution.”

If you want a poignant example of how these policies are directly affecting working people, take five minutes and read the sad story of Element Electronics (seriously, it’s a short post – you should read it).

With all of that in mind, consider the following excerpt from a new note penned by BofAML’s Ethan Harris, out Friday:

[It is an] oversimplification to ignore supply-side constraints in assessing policy effects. The objective of tariffs is to shift spending from imported to domestically produced products. However, it takes time to restructure long-established supply chains so the main initial impact of tariffs is a sharp increase in prices with little impact on domestic production. The supply response is doubly difficult when the economy is already at full employment. Indeed, given its dual mandate of full employment and moderate inflation, the Fed might have to hike faster in response to the tariffs to avoid even greater overheating.

All of that explains why Trump and Kudlow are shrieking so loudly about the U.S. economy.

Last weekend, Trump used his Twitter account and a rally in Ohio to tout the imagined benefits of his trade policies. “Tariffs are working far better than anyone ever anticipated”, Trump tweeted on Saturday, before lampooning the Shanghai Composite, which fell into a bear market earlier this year. “China market has dropped 27% in last 4 months, and they are talking to us”, the President said.

That right there was a sure sign of weakness to anyone who understands what’s actually going on here. China’s first concern wasn’t the stock market, it was shielding the economy. That’s why the PBoC countenanced yuan depreciation. In his interview with Bloomberg, Kudlow attempted to convince the American public that the yuan’s decline was somehow unfolding in spite of the PBoC. Not to put too fine a point on it, but he knows better than that. The yuan was falling with the blessing of the PBoC, which rolled out a series of easing measures that, when combined with a Fed that’s forced (by the very same economic outperformance Trump and Kudlow are so proud of) to stick to the hiking path, perpetuated the policy divergence between the U.S. and China, thereby putting market-based pressure on the currency. China then leaned on the “market forces” excuse to give themselves plausible deniability when it came to accusations of currency “manipulation”. Within two months, the yuan had depreciated enough to completely offset the first two rounds of 301-related tariffs before they were even fully implemented.

Again, Larry Kudlow knows that and so does Trump. The President’s attacks on Jerome Powell and his explicit mentions of dollar strength on Twitter are stone, cold proof that the White House is aware they aren’t “winning” this war.

As we’ve variously documented since Trump’s initial broadside on Jerome Powell, the President is caught in an “insanity loop” when it comes to the currency. Here’s an excerpt from “Presenting, The Dollar Intervention Delusion“:

But the quintessential example of Trump driving himself crazy is what we’ve variously dubbed the “dollar insanity loop” wherein the combination of late-cycle fiscal stimulus and tariffs point to higher inflation outcomes (at least in the short term) and thereby beget a more hawkish Fed. Of course a hawkish Fed is USD+, and the stronger the dollar, the less effective the tariffs. Trump’s “solution”, thus far, has been more protectionist cowbell. To the extent protectionism is inflationary in the early stages, he’s running up the down escalator. The next round of tariffs on China (targeting an additional $200 billion in Chinese imports) is likely to hit consumer goods, thereby raising the chances of an inflation overshoot.

The above-mentioned Ethan Harris breaks this down into three handy bullet points on Friday:

[It’s also an] oversimplification is to ignore how exchange rates respond to policy changes. The US is running a trifecta of dollar-positive macro policies.

1. Easy fiscal policy pushes up the dollar by boosting interest rates and stimulating imports. The new tax laws also create incentives to repatriate cash to the US and if these monies are not already in dollar assets, this could strength the dollar as well.
2. Fed tightening also pushes up interest rates, boosting the dollar.
3. And actual and threatened US tariffs strengthen the dollar as well. Tariffs tend to weaken imports, reducing US demand for foreign currency, and threatened tariffs add to global uncertainty, pushing up safe-haven currencies like the dollar.

All of these effects can be illustrated with a standard Mundell-Fleming model with flexible exchange rates and partial capital mobility. Little wonder our FX team is so bullish on the dollar.

Yes, “little wonder” the bank’s FX strategists are bullish on the greenback and “little wonder” why Trump may ultimately resort to an actual intervention in the currency market.

Of course Trump and Kudlow know there is exactly zero chance that the public understands how China manages the yuan. It’s not like voters in the farm belt have done the math on the offset here. Voters do have some vague conception of what the stock market is though, so Trump leaned on that last weekend to claim that China was losing. Here’s the clip from the Ohio rally:

(Trump stumps for Troy Balderson in Ohio, August 4, 2018)

It wasn’t clear what “market” he was referring to because the 27% figure is actually wrong if he means the Shanghai Composite (something tells me Trump doesn’t track any of the other onshore indexes) but you can actually give him the benefit of the doubt on this one because he was closer than usual when it comes to things having to do with numbers.

(Shanghai Composite languishing in bear market territory)

Simply put, Trump’s effort to pitch the decline in Chinese equities as evidence of the U.S. “winning” is a smoke screen. “After consolidating power at the 13th National Congress, Xi does not need to worry about midterms or his own re-election”, BofAML’s Harris writes, in the same note cited above. “Hence he likely does not worry about the stock market as much as a US president.”

Circling back, Beijing’s first order of business was to let the yuan weaken to shield the economy. They had a pain threshold on that which, as it turns out, was about 6.90. Beyond that, they were apparently concerned about capital flight, which is why last Friday, the PBoC stepped in to reinstate a forwards rule designed to make it more expensive to short the currency. Here’s the annotated history (we use this chart a lot and update it frequently):

(An annotated history of the PBoC’s CNY management since the 2015 devaluation)

What you should note here is that Beijing seems to have played this rather adeptly. Although not the best read on capital flight, the July reserve data actually showed a build in China’s war chest.

(China’s reserves rose by $5.8 billion to $3.118 trillion in July, the median estimate was $3.107 trillion / Bloomberg)

In other words, Larry Kudlow’s contention that “some of the currency fall is just money leaving China” isn’t true. It’s more complicated than that of course, but the “bottom line” is that so far, CNY depreciation hasn’t led to the type of outflows China hawks were probably hoping for.

“Fear itself is not enough”, BofAML wrote, in a separate note from the one cited above, adding that “the bottom line is that a combination of robust portfolio inflows, macro-prudential measures and moral suasion may be making USD/CNY more robust despite a deteriorating current account position.”

On July 31, reports (subsequently confirmed) indicated that the Trump administration is considering more than doubling the rate applied to $200 billion in Chinese imports in the next round of 301-related tariffs. The problem: it will be next to impossible to avoid a rise in consumer prices in that scenario.

A week before that news, Beijing announced that China would take a “more proactive” approach to fiscal policy going forward. That was a clear sign that officials in China were already thinking ahead. Having used the currency to offset the effects of the tariffs, the next move was to tip fiscal stimulus in an effort to address sentiment and buoy the flagging equity market. In and around that announcement, the Shanghai Composite rose 1% or more for three consecutive sessions.

The prospect of a 25% rate in the next round of tariffs served to blunt the market impact of the fiscal stimulus announcement in China, but the overall message was clear: Beijing was digging in and while Trump seemingly believes that slapping a 25% tariff on $200 billion in additional Chinese imports will force Xi to the table, what Xi knows is that Trump is effectively risking a sharp increase in consumer price inflation right around the midterm elections. Here’s BofAML’s Harris again:

The Chinese economy continues to slow, but it is hardly falling off a cliff. Chinese policymakers hope the weaker currency will more than offset the competitiveness shock from the next round of tariffs. They also see the next $200bn in tariffs on Chinese products as a double-edged sword, hurting US consumers as well as Chinese companies. The resulting sticker shock could impact US public opinion going into the midterm elections. This gives China a strong incentive to wait a few months and see how this plays out.

Well on Friday, the latest read on inflation in the U.S. showed the core index rising at the fastest pace since 2008.

All of the above seems to suggest that Xi was multiple steps ahead of Donald Trump when it came to gaming this out. The U.S. President, it would appear, is stumbling into a trap.

Additionally, the fact that Trump has made it a point to try and direct voters’ attention to the Chinese equity market while simultaneously going to absurd lengths (e.g., holding a press conference to celebrate quarterly GDP data) to paper over the early signs of trouble for the U.S. economy from the tariffs, has a “the lady doth protest too much, methinks”, feel to it.

We’ll give the final word to BofAML’s Harris:

Our call remains the same: the trade war is likely to continue to escalate until there is clear evidence of collateral damage, particularly in the US.