Trump on trade: unintended consequences?

A straightforward analysis of what Mr. Trump is doing would be:

–tariffs slow overall growth and rearrange it to favor protected industries.  There’s no reason I can see to believe something different might happen in the US

–apart from the third world, protected industries tend to have domestic political clout but to be in economic trouble.  In my experience, these woes come more from bad management than from foreigners’ actions

–the go-it-alone approach is a weak one, since it provides ample scope for a target country to shop tariffed goods through an intermediary

–the apparently arbitrary way the administration is acting will cause both domestic and foreign corporations to reconsider future capital investment in the US.

 

There are, however, two other issues that I think have long-term implications but which aren’t discussed much.

–tariffs may cause industries that have moved abroad to retain labor-intensive work practices (and continue to use dated industrial machinery) in a lower labor-cost environment to return to the home country.  If such firms come back to the US, it won’t be with the old machinery.  New operations will be very highly mechanized. In other words, one likely response to the Trump tariffs will be to accelerate the replacement of humans with robots in the US.

–as I see it, China is at the key stage of economic development where, to grow, it must leave behind labor-intensive work and develop higher value-added industries.  This is very hard to do.  The owners of low value-added enterprises have become very wealthy and powerful.  They employ lots of people.  They have considerable political influence.   And they strongly favor the status quo.  The result is typically that the economy in question plateaus as labor-intensive industries block progress.  In the case of China, however, the threat that the US will effectively deny such firms access to a major market will kickstart progress and deflect blame from Beijing.

 

If I’m correct, the effect of trying to restore WWII-era industry in the US will, ironically, achieve the opposite.  It will accelerate domestic change in the nature of work away from manual labor.  And it will run interference against the status quo in China, allowing Beijing’s efforts to become a cutting-edge industrial power to gather speed.

 

 

slowdown in China

In the late 1970s Deng Xiaoping was forced to tackle the gigantic mess that central planning had made of the Chinese economy during Mao’s rule.  The problem:  highly inefficient, loss-making, corruption-infested, Soviet-style (feel free to add more negative, hyphenated adjectives) state-owned enterprises dominated the industrial base.  The products were poor;  the books more fiction than not.  Deng’s solution was to adopt Western-style capitalism under the banner of “Socialism with Chinese Characteristics.”  This meant pulling the plug on bank credit and political favor for state-owned enterprises and redirecting support toward the private sector.

The result has been 30+ years of economic growth so strong that it has vaulted China from nowhere into first place among world economies.  In fact, the PRC is now 10%+ larger than #2, the US, using Purchasing Power Parity as the yardstick.

According to an astute observer of China, Nicholas Lardy, writing in the Financial Times, however, current Chinese leader Xi Jinping has not simply been cracking down on the cumulative excesses of the private sector over the past couple of years.  He has also reversed Deng’s policy in favor of building up the state-owned sector again.  Lardy thinks this decision is reducing China’s annual GDP growth rate by a whopping two percentage points.

I’m not sure why this is happening.  But for China, the highest economic principle has never been about achieving maximum sustainable GDP growth.  Rather, it’s whatever is necessary to maintain the Communist Party in power.  Reduction in GDP growth is a secondary concern.

 

I don’t know how this affects China’s stance in tariff negotiations with the US, especially since White House economists seem to be suggesting that the US economy is already beginning to contract under the weigh of current tariffs plus the government shutdown   (increased tariffs slated for March will only deepen any decline).  From a longer-term point of view, though–and assuming Chinese policy doesn’t change–for a company to simply have exposure to China will no longer be any guarantee of success.

 

internet companies vs. state-owned enterprises in China

Recently Beijing announced it wants to take equity positions in the major internet companies in China and place Communist Party officials on their boards of directors.

What’s going on?

I see two general possibilities.

Some background first.

Deng’s economic reform

In the late 1970s, Deng Xiaoping realized that the Chinese economy was too big to be controlled through central planning.   To grow it had to adopt Western economic (but not political) methods.  So he began to allow the market, not doctrinally-correct political cadres, to dictate the direction of expansion.

A major issue he faced in doing so was that, say, three-quarters of Chinese industry was owned by the state.  These companies were rudderless, and hopelessly inefficient–but they employed tons of people.  If large numbers lost their jobs all at once, the ensuing social instability might threaten the rule of the Party.  Therefore, economic progress had to be tempered by the need to avoid this outcome.  And this in a nation without sophisticated macroeconomic tools to control the pace of growth.

The result over three+ decades has been a Chinese economy that lurches between boom and bust, depending on the temperature in the state-owned enterprises.  The strategy has generally been successful, I think, with the state-owned sector now representing less than a third of China’s overall output.

possibilities

–China’s internet companies have become large enough that their actions, intentional or not, can accelerate the speed at which state-owned companies shrink.  So they need to be monitored much more carefully than in the past.  This is the benign interpretation, and the one which share prices suggest the market has adopted

–China’s internet companies have become large enough to generate “creative destruction” in large enough amounts to threaten the economic control over China exercised by the Communist Party itself.  If this is the case, then the oversight over domestic internet conglomerates will be much more draconian than the consensus expects.  That would presumably result in considerable PE contraction for the firms being controlled.

My guess is that the first possibility is much more likely to be the case.  But I think we should watch the situation closely for new hints about Beijing’s intentions.

the amazing shrinking dollar

So far this year, the US$ has fallen by about 14% against the €, and around 8% against the ¥ and £.

A substantial portion of this movement is giveback of the sharp dollar appreciation which happened last year after the surprise election of Donald Trump as president.  That was sparked by belief that a non-establishment chief executive would be able to get things done in Washington.  Reform of the income tax system and repair of aging infrastructure were supposed to be high on the agenda, with the resulting fiscal stimulus allowing the Fed to raise interest rates much more aggressively than the consensus had imagined.  Hence, continuing dollar strength on a booming economy and increasing interest rate differentials.

To date, none of that has happened.   So it makes sense that currency traders would begin to reverse their bets on.  However, last year’s move up in the dollar has been more than completely erased and the clear consensus is now on continuing dollar weakness.

 

Dollar weakness has caused stock market investors to shift their portfolios away from domestic-oriented firms toward multinationals and exporters.  This is the standard tactic.  It also makes sense:  a firm with costs in dollars and revenues in euros is in an ideal position at present.

It’s interesting to note, though, that over the weekend China lifted some restrictions imposed last year that limited the ability of its citizens to sell renminbi to buy dollars.

To my mind, this is the first sign that dollar weakness may have gone too far.

It’s too soon, in my view, to react to this possibility.  In particular, the appointment of a new head of the Federal Reserve could play a key role in the currency’s future path, given persistent Republican calls to curtail its independence.  Gary Cohn, the establishment choice, is rumored to have fallen out of favor with Mr. Trump after protesting the latter’s support of neo-Nazis in Charlottesville.

Still, it’s not too early to plot out a potential strategy to benefit from a dollar reversal.

 

 

Jeep as a Chinese brand

A mainland Chinese company, Great Wall Motor of China, has recently expressed interest in acquiring either the Jeep brand + manufacturing operations or all of Fiat/Chrysler.

The press has since been filled with commentary whose thrust is that Washington will oppose either sale proposition.

Several things strike me as odd about this:

–brands like Volvo and Jaguar have looked a lot more interesting recently since coming into Asian hands, so that shouldn’t be an issue (although this is likely the crux of the matter)

Jeep is now part of an Italian company   …which bought it from a German firm that was slowly sinking under the weight of a senescent Chrysler   …which had been foundering despite a government bailout in the 1970s and a huge injection of badly needed engineering talent under Daimler.  So a firmer economic footing for the whole Chrysler enterprise is unlikely to come without outside-the-box thinking.  Also, it’s hard to make a logical argument that foreign ownership for any part of Chrysler is a problem

–if the Great Wall Motor interest is real, it suggests the company has access to foreign exchange at a time when Beijing is cracking down on reckless foreign m&a by domestic corporations.  That likely means that Great Wall has enough influence in China to be able to expand the Jeep brand’s reach quickly

–I haven’t heard a lot of posturing from Washington.  Either I’m really out of touch on this one, or the anti-Great Wall sentiment is mostly in the minds of reporters.

Chinese economic growth

China, the largest economy in the world (by Purchasing Power Parity measurement), reported 1Q17 economic growth of 6.9% earlier today.  The best analysis of what’s going on that I’ve read appears in the New York Times.

The bottom line, though, is that this is a slight uptick from previous quarters–and good news for the rest of the world, since one of the big factors that is driving growth is exports.

Traditionally, the first question with Chinese statistics has been whether they attempt to represent what is happening in the economy or whether they’re the rose-colored view that central planning bosses insist must be shown, whatever the underlying reality may be.

I think this is a much less worrisome issue now than, say, ten years ago.  But in addition to greater faith in statisticians, we also have other useful indicators about the state of China’s health.  They’re all positive:

–As I wrote about a short while ago, demand for oil in China is rising.

–Last week, port operators reported an activity pickup, led by exports.

–And Macau casino patronage, which bottomed last summer, is showing surprising increases–with middle class customers, not wealthy VIPs, in the vanguard.

While I think that consumer spending in the US is probably better than recent flattish indicators would suggest (on the view that statistics are catching all of the pain of establishment losers but much less of the joy of new retail entrants), my guess is that increasing export demand for Chinese goods is coming from Continental Europe.

More tomorrow.

Shenzhen Connect starts next week

…on December 5th.

That’s according to the Hong Kong Exchanges and Clearing Limited (HKEX), whose Stock Exchange of Hong Kong subsidiary signed an agreement with its Shenzhen counterpart on rules for Shenzhen Connect last month.  The agreement was just approved by mainland Chinese regulators.

what is Shenzhen Connect?

It’s a mechanism that allows investors in Hong Kong to buy or sell Shenzhen-listed stocks, up to a specified (but large) total daily limit.  It also allows China-based investors to buy and sell Hong Kong-listed stocks through the Shenzhen Exchange.

The start of Shenzhen Connect trading follows the successful establishment of a similar arrangement between Hong Kong and Shanghai, called Stock Connect, a little more than two years ago.

significance?

In a practical sense, Shenzhen Connect and Stock Connect together end the closed nature of the Chinese stock market.  Doing so is an important economic objective of Beijing.  It’s another step down the road to dismantling the central planning and control that has characterized Chinese socialism since WWII.

rising Shenzhen shares?

Will this signal a boom in Hong Kong interest in China-listed shares?  I don’t think so, but it will be interesting to watch and find out.

Stock Connect, which opened the Shanghai stock market to foreigners wasn’t such a big deal, in my view.  That exchange is dominated by state-controlled banks and by stodgy old industrials headed mostly by state functionaries with no idea of how to run a profitable business.  Beijing will protect the banks but is content to let the  gradually wither and die.  So I didn’t see any rush to be the first foreigner to arrive in 2014.

The Shenzhen Exchange, on the other hand, is home to much more entrepreneurial firms, with little or no official state involvement.  So, in theory, yes, I might want to participate.

A big roadblock for me, though:  I have no idea whether I can trust the financial reports that companies issue.

Two ways to find out: listen carefully to what local players say and do; and visit the companies that sound interesting, interview the managements–and then watch to see how what they say matches up with operating results and what the financials report.

Even then, my experience is that you may not be safe.  Years ago, I visited a small Hong Kong manufacturing company at the urging (I didn’t need much) of a friend.  The firm told me a fabulous story of its success making computers for children.  I went back to see the management some months later.  They didn’t recognize me as a person they’d spoken with before.  This time they told me an equally dollar-sign-filled story, but this time they were an auto parts firm.  Whoops.

I’m not willing/able to put in the effort required to understand how the stock market game is played in Shenzhen.  So, Shenzhen Connect won’t tempt me away from the sidelines.