Trade wars Archives - Page 2 of 2

AIG, Robert E. Lighthizer, Made in China 2025, and the Semiconductors Bull Market

“The icon of modern conservatism, Ronald Reagan, imposed quotas on imported steel, protected Harley-Davidson from Japanese competition, restrained import of semiconductors and automobiles, and took myriad similar steps to keep American industry strong. How does allowing China to constantly rig trade in its favour advance the core conservative goal of making markets more efficient? Markets do not run better when manufacturing shifts to China largely because of the actions of its government.” – Robert E. Lighthizer

“Patience is essential. We should step back, take a deep breath and examine carefully the ties that bind us together.” Maurice “Hank” Greenberg, former CEO of American International Group, at the congressional hearing on US-China economic ties in May 1996

American International Group (AIG), the once venerable multinational insurance group, was founded in 1919 in Shanghai, where it prospered until the communists forced it to leave in 1950. AIG had to wait over four decades to re-enter the Chinese market. In 1992, AIG became the first foreign insurance company licensed to operate in China and established its first office on the Mainland in Shanghai.

We doubt it was sentiment that led China to grant AIG the license. After all, there is little room for sentiment in the high-stakes game of global trade.

In 1990, Maurice “Hank” Greenberg, then chief executive of AIG, had been appointed as the first chairman of the International Business Leaders’ Advisory Council for the Mayor of Shanghai. In 1994, Mr Greenberg was appointed as senior economic advisor to the Beijing Municipal Government. In 1996, at the time when China’s status as Most Favoured Nation (MFN)[1] was under threat due to a resolution put forth to the House of Representatives in the US, he was appointed as the Chairman of the US-China Business Council.

While all of above mentioned appointments may have raised an eyebrow or two, they do not amount to much in and of themselves. When we throw in the fact that Mr Greenberg had been part of the President’s Advisory Committee for Trade Policy and Negotiations since the 1970s – the official private-sector advisory committee to the Office of the US Trade Representative – we begin to realise the possible reason why the Chinese leadership took a liking to Mr Greenberg and afforded his company the luxury of becoming the first foreign insurer to operate in China.

In May 1996, Mr Greenberg, during a key congressional hearing on US-Sino economic ties, testified in favour of not only renewing China’s MFN status but also making it permanent.

There we have it: quid pro quo.

In June 1996, the House of Representatives endorsed China’s MFN status by a vote of 286 to 141. At the time of vote AIG had eleven lobbyists representing its interests in Washington. One of those lobbyists was Skadden, Arps, Slate, Meagher & Flom, where AIG’s affairs were handled by one Robert E. Lighthizer – the current United States Trade Representative.

Senior American and Chinese officials concluded two days of negotiations on trade and technology related grievances the Trump Administration has with China. As many may have suspected, the talks appear to have achieved little despite the US sending a team comprised of top-level officials including Treasury Secretary Steven Mnuchin, Trade Representative Robert Lighthizer, White House trade advisor Peter Navarro, Secretary of Commerce Wilbur Ross, and National Economic Advisor Larry Kudlow.

As part of the talks the US representatives have submitted an extensive list of trade and technology related demands. In our opinion, the demands represent a hodgepodge of objectives as opposed to one or two key strategic objectives the Trump Administration may have – symptomatic of the differing views held by the various members of the US team. We expect US Trade Representative Robert E. Lighthizer to slowly take control of proceedings and to set the agenda for US-China trade relations – after all he is the only senior member of the team with meaningful experience in negotiating bilateral international agreements.

Mr Lighthizer’s primary objectives with respect to US-Sino trade relations are (1) for China to open up its economy – by removing tariffs and ownership limits – for the benefit of Corporate America and (2) to put an end to Chinese practices that erode the competitive advantages enjoyed by US corporations – practices such as forcing technology transfer as a condition for market access.

Mr Lighthizer’s goals are ambitious. They will require time and patience from everyone – including President Trump, Chinese officials, US allies, and investors. For that, he will need to focus Mr Trump’s attention on China. He will not want the President continuing his thus far ad hoc approach to US trade policy. If NAFTA and other trade deals under negotiations with allies such as South Korea are dealt with swiftly, we would take that as a clear signal that Mr Lighthizer is in control of driving US trade policy.

Unveiled in 2015, “Made in China 2025” is China’s broad-based industrial strategy for it to become a leader in the field of advanced manufacturing. The strategy calls for directed government subsidies, heavy investments in research and innovation, and targets for local manufacturing content.

To date, China’s industrial base is dominated by manufacturing of basic consumer products such as clothing, shoes and consumer electronics. The overwhelming majority of technologically advanced exports out of China have been made by multinational companies. The Made in China 2025 strategy identifies ten key areas – such as robotics, electric and fuel-cell vehicles, aerospace, semiconductors, agricultural machinery and biomedicine – where China aims to become a global leader. And it is these very industries that Mr Lighthizer aims to attack for the benefit of Corporate America.

One area where China is clearly at the cutting edge of global research is artificial intelligence. According to research published by the University of Toronto, 23 per cent of the authors of papers presented at the 2017 Advancement of Artificial Intelligence Conference were Chinese, compared to just 10 per cent in 2012. And we suspect, especially given the Chinese leadership’s dystopian leanings, China is going to be unwilling to relent on its progress in artificial intelligence regardless of the amount of pressure the Trump Administration applies.

Artificial intelligence requires immense amounts of computing power. Computers are powered by semiconductors. China cannot risk its AI ambitions by being hostage to semiconductor companies that fall under the US sphere of influence. China, we believe, will pull out all the stops over the next decade to develop its local semiconductor industry manufacturing capabilities with an aim to end its reliance on US-based manufacturers by 2030.

Investment Perspective

Investors often talk about the one dominant factor that drives a stock. While we consider capital markets to be more nuanced than that, if semiconductor stocks have a dominant factor it surely has to be supply – it certainly is not trailing price-to-earnings multiples as semiconductor stocks, such as Micron, have been known to crash when trading at very low trailing multiples. Chinese supply in semiconductors is coming.

While we expect the bull market in tech stocks to re-establish itself sometime this year, if there was one area we would avoid it would be semiconductors.

[1] From Wikipedia: MFN is a status or level of treatment accorded by one state to another in international trade. The term means the country which is the recipient of this treatment must nominally receive equal trade advantages as the “most favoured nation” by the country granting such treatment. (Trade advantages include low tariffs or high import quotas.) In effect, a country that has been accorded MFN status may not be treated less advantageously than any other country with MFN status by the promising country. There is a debate in legal circles whether MFN clauses in bilateral investment treaties include only substantive rules or also procedural protections.

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein

Trade Wars: Two Can Play That Game

“One day, she’ll start sending you mixed signals, and you’ll get mad because she finally learned how to play your game.” – Unknown

“Hold out baits to entice the enemy. Feign disorder, and crush him.” – The Art of War by Sun Tzu

“A slander is like a hornet; if you cannot kill it dead at the first blow, better not to strike at it.” – Henry Wheeler Shaw, 19^th century American humourist who used the penname Josh Billings

The United States is the only western country that continues to apply the death penalty to this day. Capital punishment is used as legal penalty across 31 American states and by the US federal government and the US military. The Bill of Rights – the first ten amendments to the US Constitution that were adopted in 1789 – included as part of the Eighth Amendment the prohibition of cruel and unusual punishment. Following the Bill of Rights, punishments such as drawing and quartering, public dissection, burning alive, and disembowelment were recognised as cruel and unusual punishments and consequently outlawed by the Supreme Court.

Capital punishment also survives in the People’s Republic of China till this day. Cruel and brutal practices in serving the death penalty were also abolished in China but much later than they were in the US. One practice used by the Chinese was particularly barbaric. Far more barbaric than any practice that may have been used in the US even prior to the passing of the Bill of Rights.

The ancient Chinese practice known as lingchi – more commonly referred to as death by a thousand cuts – was not officially outlawed in China until 1905. Lingchi was a long, drawn out punishment, intended to test how many cuts a person could withstand before dying.

President Donald Trump has this week announced plans to impose tariffs on Chinese imports amounting up to US dollar 60 billion. The plan is based on applying a 25 per cent import duty on a yet to be determined list of Chinese products. Mr Trump has unleashed the firing squad with the intent, according to US officials, of derailing Chinese high-tech ambitions. General Secretary Xi Jinping has identified ten key areas – such as robotics, electric and fuel-cell vehicles, aerospace, agricultural machinery and biomedicine – as part of his “Made in China 2025” initiative. These are the sectors that the Trump Administration aims to attack through the planned tariffs. Mr Trump and his band of trade warriors, not content with import tariffs alone, are also looking to introduce legislation placing new restrictions on Chinese investment into the US in the aforementioned industries.

In hope of rattling the hornet’s nest some more, the Trump Administration granted temporary exemptions – until 1^st May – on steel and aluminium tariffs announced earlier this month to a number of US allies, including the European Union, Australia, South Korea, Argentina, and Brazil.

To top it all off, President Trump replaced national security adviser Herbert Raymond McMaster with super-hawk John Bolton.

In response to the US’s plans to introduce tariffs on Chinese imports, China’s Ministry of Commerce said it is planning to place import tariffs on 128 US products representing US dollar 3 billion in imports. Tariffs will be placed on products such as US steel pipes, recycled aluminium, pork, fresh fruit, and wine. To some Beijing’s reaction appears measured, to others it seems meek. In our opinion, Beijing has just made its first cut; it has a thousand more lined up. How many cuts they make depends on Washington.

Ever since Mr Trump abandoned the Trans Pacific Partnership, Mr Xi has taken it upon himself to become the primary advocate of global trade and in turn positioning China to play a greater global role. The measured response is sound politics. Beijing will not want to come off looking aggressive or to take steps that could derail global trade. For seemingly undue aggression from China would push Europe and other American allies to align with the US – something they have thus far resisted in doing.

Investment Perspective

Mr Trump, in our opinion, is not the crazed madman with too much power to wield as some segments of the mass media would have us believe. Instead, we think he has two immediate goals in mind when it comes to China: to shore up his voter base; and to send China the signal that the rules of engagement have changed. The latter goal is something a number of commentators and analysts have pointed to while citing Mr Trump’s interview with Oprah Winfrey in 1988. While we have no reason to doubt that Mr Trump indeed is approaching the situation in the way he described he would to Ms Winfrey three decades ago, we must also accept that the world we live in today is drastically different to the one that existed at the time of that interview. The rise of China is amongst the most far-reaching changes over the last three decades.

Before the rise of China, the US was already running trade deficits – in effect borrowing US dollars – and supporting the internationalisation of leading US companies. These companies invested all over the world and became what today are commonly referred to as multinational corporations. These multinationals used, in effect, US debt to fuel international expansion and generated returns that far exceeded the interest cost the US incurred on its debt. The end result being that the US was able to collect the spread between the return on investment on the multinationals’ international operations and the cost of its debt.

The rise of China has had a profound impact on the above described dynamic. First, it has led to US multinationals earning much higher returns on their international investments. Second, China has as a matter of policy helped reduce the cost of US debt. The end result: the US earned an even juicier spread on its international investments.

As any corporate financier worth their salt will attest to, when such a spread is available to exploit you should continue to add leverage till the point the marginal benefit of additional leverage is zero. And this is exactly what the US did. Wall Street won at the cost of Main Street.

Donald Trump by unleashing a trade war is attempting to reverse this trend. The consequence of which is that the US’s net investment income that has been positive for so long will turn negative. Leverage after all cuts both ways. For his protectionist policies to yield long-term results tariffs may not be enough, however. Mr Trump will need both a much higher interest rate and a stronger US dollar. Given where US debt levels stand and the US Treasury’s borrowing needs for the coming years can the US withstand this policy? We think not.

We do not want to be long the US dollar. Tactical positioning aside of course.

Trade Wars: Hedging for Tariffs

“You realise that all the lines on the maps really do not exist. You can’t even tell where one country starts and the other one stops. All those things that create conflict just melt away, and you can see our planet as one home for all of us.” – Anousheh Ansari, Iranian-American astronaut’s reflection upon seeing the earth in its entirety

“No nation was ever ruined by trade.” – Benjamin Franklin

“The whole is more than the sum of its parts” – Aristotle

“We can only see a situation with true clarity when we take the time to carefully consider the interests at hand. And we understand it even better when we consider how the situation might be different if the underlying interests were different.” – Excerpt from Pebbles of Perception: How a Few Good Choices Make All the Difference by Laurence Endersen

The government of Israel has for many years placed a complete ban on trade with Iran. In fact, Israeli law stipulates the penalty for violating the ban on Iranian imports can be as high as imprisonment of up to two years. Despite this, Iranian marble, it turns out, is a notable feature of some of the most prominent buildings in Israel.

A complex adaptive system is a system in which a complete understanding of the individual components does not directly translate into a comprehensive understanding of the system’s behaviour as a whole. The global trade system that enables the cross-border exchange of goods and services is a type of complex adaptive system. It is the adaptive nature of this system that enables the availability of Iranian marble in Israel.

President Trump and his posse of international trade warriors is, by unveiling their first wave of import tariffs, attempting to change the dynamics of the global trade system. How the individual and collective components of the system mutate in response to the Trump Administration’s policies is anyone’s guess. What is an almost foregone conclusion, however, is that system’s response will include second and third order effects – the so called unintended consequences – that US policymakers will not have anticipated.

Our rudimentary attempt at diagnosing some of the potential unintended consequences of the Trump Administration’s protectionist theatrics is based on identifying how the prominent players within the global trade system are incentivised. The European Union is one of the major players within the system we consider to be trapped by a complex web of incentives. The predicament faced by the bureaucrats in Brussels is of an existential nature. Existential threats activate the most basic of human instincts – the instinct of survival. And the thing about basic human instincts is that they can cause the most rational of agents to behave irrationally.

The bureaucrats in Brussels are unelected officials. Their only claim to legitimacy comes from the existence of the European Union. These bureaucrats it leads are incentivised to ensure the survival of the European project. This survival depends on the union members maintaining their memberships. It is therefore in this context only rational for the bureaucrats to heavily punish any wantaway member even if said wantaway member happens to be running a huge trade deficit with Europe. The bureaucrats in Brussels, we believe, want to severely punish the UK for the British populous’ decision to exit the European Union.

We fully expect the leaders of the European project to continue to drive a hard bargain in the negotiations on the terms of UK’s exit from Europe – at least in the short-term. The bureaucrats may or may not realise it but the protectionist turn in President Trump’s policymaking has tilted the balance in the UK’s favour and the British government now has the upper hand when it comes to the Brexit negotiations.

The Trump Administration placing tariffs on steel and aluminium imports will increase cost pressures faced by US auto manufacturers – making their vehicles, in all likelihood, uncompetitive in relation to imported vehicles. German automakers exported more than half a million vehicles to the US in 2016 and Germany runs, what we suspect to Mr Trump’s international trade warriors is, an unpalatable level of trade surplus with the US. Should the metal import tariffs be successfully enacted by the Trump Administration, we suspect that German automakers will find themselves at the centre of the next round of Mr Trumps’ protectionist theatrics.

In 2016 the UK ran a GBP 82 billion trade deficit with imports from EU representing 54 per cent of the UK’s imports during the year. German automobiles represented a not so insignificant share of those imports.

Now consider the incentives for the German government. After months of uncertainty Germany has a new government with the Social Democratic Party of Germany (SPD) finally agreeing to a coalition with Chancellor Angela Merkel’s Christian Democratic Union of Germany (CDU). Chancellor Merkel in a bid to secure a fourth-term had to relinquish control of the finance ministry to the SPD. For the SPD the coalition offers an opportunity to position itself as a viable alternative to the CDU for the next election. The CDU on other hand does not want to lose any further ground to the SPD. Collectively the parties want to stop the rise of the nationalist Alternative Party of Germany party. The closure of factories operated by German automakers serves neither party’s objectives. The rational course of action for the German leadership in this context is to reach an amenable trade agreement with the British.

What the bureaucrats want and what Germany needs may test the cordial relationship that may exist between Brussels and Berlin today. The fact, however, remains that there is no European project without Germany and the Germans will eventually get their way. For this reason, we expect Brexit negotiations between the UK and Brussels to turn decidedly in the favour of the British.

Investment Perspective

The time, we think, to buy UK stocks is coming. Exporters benefited at the cost of domestically focused companies as the British pound fell sharply following the Brexit referendum. The tide, in our opinion, is turning and we favour more domestically focused British companies over exporters. We also think the sterling should strengthen relative to the Euro.

Domestically focused British companies may, in our opinion, be amongst the best available hedges to the rising level of protectionist rhetoric coming out of the US.

On the European front, we favour domestically focused automakers in France and Italy over the more export oriented German auto manufacturers. The domestically focused automakers, we think, should benefit from lower steel and aluminium prices as non-US based steel and aluminium producers redirect their supply toward Europe and Asia.