05 Aug 2019

Action and Reaction

Investec

UK economists

US President Donald Trump’s recent loss of patience is a big blow for equity markets, and this has dramatically raised the risk of an aggressive reaction from China.

 

This article forms part of the UK's 'Weekly Digest' series.

Receive Focus insights straight to your inbox

Sending...

Please complete all required fields before sending.

Thank you

We look forward to sharing out of the ordinary insights with you

Sorry there seems to be a technical issue

The temperature in financial markets has suddenly turned decidedly chilly. Signs of unease were already apparent in falling global bond yields, suggesting that all was not well with the growth outlook.

 

The mood had not been helped by the state of open conflict between the American administration and the Federal Reserve regarding the appropriate monetary policy setting in the world’s largest economy, a factor that introduces uncertainty for all who use the dollar extensively in their daily business.

 

The straw that has broken the proverbial camel’s back for equity investors, however, has been President Trump losing patience with the progress of trade talks with China and, on Thursday last week, deciding to impose 10% tariffs on the $300bn of Chinese imports to the US that had until then been tariff free.


Equity markets have taken this poorly for a number of reasons. First, because it was unexpected – there had been no official severance of the negotiations that had only just recommenced following the G-20 meeting between Xi Jinping and President Trump at the end of June.

 

Second, because the move, together with the accompanying threat to increase the magnitude of the tariffs still further, raised the risk that China would push back more aggressively than in the past – taking the trade conflict to an entirely new and riskier (for global growth) level.

The Chinese Yuan has weakened below the psychologically important seven yuan per dollar rate, a level it last saw in June 2008.

This morning, those fears appear to be well-founded. The Chinese Yuan has weakened below the psychologically important seven yuan per dollar rate, a level it last saw in June 2008. Why is this significant? It is because, given that the Yuan is a managed currency, this could only have happened with the support of the Chinese authorities.

 

Up to now, in spite of the trade tensions and the tariffs imposed so far, the Chinese have gone out of their way to keep the Yuan stable. This year it has traded between 6.7 and 6.95 to the dollar, with most of the movement being explained by dollar strength rather than Yuan weakness.

 

Allowing the currency to move past a “big figure” signals one of two things – either that China’s patience with megaphone diplomacy has run out, or that something in China is causing currency flight that cannot be controlled. Neither of these interpretations is positive for investors.

Until now the Chinese have simply reacted to American actions, but this opens up a new policy front and sets the US on a course to officially declaring China a “currency manipulator”

The former (a deliberate weakening) ups the ante in the trade conflict. Until now the Chinese have simply reacted to American actions, but this opens up a new policy front and sets the US on a course to officially declaring China a “currency manipulator” – embedding the conflict deeper into Sino / American relations.

 

The fact that China has, at the same time, reportedly instructed its state purchasing organisations to cease buying American agricultural products, suggests this is the truth of the matter.  The latter, if true, would be even less appealing, since the prospect of the world’s second-largest economy commencing a downward spiral as liquidity fled, would be highly unwelcome in an already uncertain climate for investors and businesses.

 

In spite of the unrest in Hong Kong, there is little evidence of this. In fact, Hong Kong may be part of the reason for a more robust response to America’s recent actions than in the past. Signs of weakness may be less tolerable in this context.

 

What now? A rational observer would still suggest that America and China have far more to lose than to gain by an escalation in the trade conflict. We should expect a calming in tensions later in the year.

 

In the near term, however, it is difficult to see how either side can back down from their new positions.  Unfortunately, it is business confidence, particularly in Europe, which relies more heavily than the US on global trade, which is the true hostage in this situation.

  • Disclaimer

    This newsletter is for professional financial advisers only and is not intended to be a financial promotion for retail clients. The information in this document is for private circulation and is believed to be correct but cannot be guaranteed. Opinions, interpretations and conclusions represent our judgement as of this date and are subject to change. The Company and its related Companies, directors, employees and clients may have positions or engage in transactions in any of the securities mentioned. Past performance is not necessarily a guide to future performance. The value of shares, and the income derived from them, may fall as well as rise. The information contained in this publication does not constitute a personal recommendation and the investment or investment services referred to may not be suitable for all investors. Copyright Investec Wealth & Investment Limited. Reproduction prohibited without permission.

     

    Member firm of the London Stock Exchange. Authorised and regulated by the Financial Conduct Authority. 

     

    Investec Wealth & Investment Limited is registered in England.

     

    Registered No. 2122340. Registered Office: 30 Gresham Street, London EC2V 7QN.