“Progress is impossible without change, and those who cannot change their minds cannot change anything.” – George Bernard Shaw
“The first rule of business is: Do other men for they would do you.” – Charles Dickens
“Globalization and trade liberalization were supposed to make us all better off through the mechanism of trickle-down economics. What we seemed to be seeing instead was trickle-up economics, accompanied by a destruction of democratic politics, as we moved ever closer to a system of ‘one dollar, one vote’ as opposed to ‘one person, one vote.’” – Joseph Stiglitz
The US Consumer is Not Immune from the Trade War
On 6 July 2018 the first tranche of tariffs imposed by the Trump Administration on China went into effect. The first tranche amounts to a 25 per cent import duty on 818 Chinese goods, representing US dollars 34 billion of China’s exports to the US in 2017. The first set of tariffs primarily target industrial goods such as aircraft engines and engine parts, cranes, nuclear reactors, electricity transformers and industrial magnets.
On 24 September 2018 the second tranche of tariffs on Chinese imports went into effect. Import duties on goods targeted in the second tranche started at 10 per cent and will rise to 25 per cent from 1 January 2019. All manner of Chinese goods, constituting roughly US dollars 200 billion of China’s exports to the US in 2017, have been hit in the second wave of tariffs. Targeted products include consumer goods such as furniture and luggage, agriculture products such as fruit and seafood, and industrial products such as chemicals and printed circuit boards.
The imposition of tariffs on Chinese goods has coincided with the gradual depreciation of the Chinese yuan. From its peak in April, the Chinese yuan has dropped by approximately 11 per cent. The drop in the currency is seen by many as a means by which China aims to counter the 10 per cent import duty imposed on its exports.
In reaction to the steady depreciation of the Chinese yuan this year, a narrative has started to take hold amongst those with a pro-tariff / anti-China disposition. That narrative being that the US consumer will be sheltered from the negative effects of a trade war as China will simply continue depreciating its currency in response to the tariffs. And a further 15 per cent decline in the value of the Chinese yuan relative to the US dollar is being anticipated ahead of the increase in import duties to 25 per cent on goods targeted in the second tranche of tariffs.
Chinese Yuan to US Dollar Exchange Rate
Source: Bloomberg
While the currency devaluation argument has merit, we do not agree with the view that the US consumer is immune to the effects of the trade war. A cheaper currency does not solve everything. Raw materials prices for Chinese exporters have increased in local currency terms and pushed up their costs, especially for producers with inputs comprising of commodities or imported products priced in US dollars.
Contrary to the view that the US consumer will not be impacted by trade wars, the recent decline of the Chinese yuan against the US dollar does not mean exporters can cut prices, in US dollar terms, to entirely offset the impact of the imposed tariffs, especially as most exporters operate with very thin profit margins.
In our estimation, under an optimistic scenario, the depreciation of the currency will only support to offset about 50 per cent of the import duties. Implying that, in most cases, the cost of tariffs will have to be shared by Chinese exporters and US consumers.
Prices for US consumers, however, should not start rising immediately. US companies are preparing for the increased tariffs by purchasing higher levels of inventories from Chinese exporters. This also means that Chinese exporters are still to feel the pinch from tariffs. Based on anecdotal evidence we have gathered, Chinese exporters are inundated with orders and are operating at full capacity to ensure US bound orders are fulfilled in time to reach US ports ahead of the 1 January 2019 deadline.
A necessary corollary of the accelerated demand from US importers this year is that the first quarter of 2019 is going to be very tough for Chinese exporters. And US consumer prices are likely to start increasing in the second or third quarter of next year.
US consumer discretionary stocks have had a pretty good run in 2018; the time to start rotating out of the sector is approaching fast.
China Doubles Down on the Consumer
At last year’s 19th Annual Communist Party Congress Xi Jinping highlighted the need to tackle financial risks as one of the priorities for the Chinese leadership. Following the event, the government took steps to clampdown on the shadow banking sector. New regulations were introduced to close loopholes that were being exploited both by banks and asset management companies to funnel loans under the guise of investment. Consequently, credit growth in China has stalled – possibly even more so than the Chinese leadership may have anticipated.
China Money Supply M2 Year-over-Year
Source: Bloomberg
Facing the escalating trade dispute with the US and the marked slowdown in credit growth, China has been under pressure to use fiscal policy more aggressively to support the economy. The government has so far resisted the urge to ramp up fiscal spending – possibly wanting to hold on to the option to combat further economic challenges in 2019.
Instead of increasing fiscal spending the Chinese government has focused on reducing reserve requirements for banks and providing inducements to Chinese consumers to increase spending.
In our view, reserve requirements cuts are unlikely to change the trajectory of either credit or economic growth in the near term. The government still remains committed to its financial de-risking campaign, and while there have been noises about scaling it back, there is little sign of it happening.
China needs increased spending to spur its economy forward and if it is not going to come from the government, it has to come from the consumer. And this is where it seems the Chinese government is focusing its near terms economic policy.
A sharp rise in consumer and household debt is what drove China’s economic growth in recent years. The build-up in household debt has been quite rapid, and in some coastal areas of China debt levels are now quite high. Consequently, compelling Chinese consumers to borrow more does not appear to be a viable policy option. For this reason the Chinese government has instead opted for tax cuts.
In September, China implemented its first income tax cut in seven years. Moreover, the implementation date of the tax cut was brought forward to 1 October from 1 January. The major change in the new tax regime is an increase in the threshold for paying tax to Chinese yuan 60,000 in annual compensation, from Chinese yuan 42,000 – individuals will not pay tax on their first Chinese yuan 60,000 of income. This change delivers a tax cut at all levels of income.
Further cuts apply for the first four of China’s seven income-tax brackets. The benefits of the tax cuts are highest for those with monthly incomes of Chinese yuan 10,000 to 50,000, with the cuts representing approximately 6 per cent of their income.
In total, these changes, according to the Ministry of Finance, will reduce revenue from the personal income tax by about Chinese yuan 320 billion – equivalent to roughly 1 per cent of annual household income. Also according to the Ministry of Finance, the share of the population paying income tax will fall 44 per cent to 15 per cent as a result of the changes to the income tax law.
More recently, the Chinese government has introduced plans to let households deduct major expenses such as housing and education from their income taxes. An estimated 80 per cent of households stand to benefit from the change and the tax burden on lower and middle class households is expected to be reduced by as much as 25 to 30 per cent
There has also has been news that China is considering a tax cut to revive its flagging automotive market.
There is little reason to doubt that the Chinese government will do more to support growth as and when it becomes necessary. For now, however, it may be time to go bottom fishing in beaten down Chinese consumer plays.
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 has been obtained from sources believed to be reliable, but not guaranteed.
Source: The World Bank
Sources: Bureau of Economic Analysis, Bureau of Labor Statistics
Source: Bureau of Labor Statistics
Source: Bureau of Labor Statistics
Source: National Federation of Independent Business
Source: Bureau of Labor Statistics
Sources: Bureau of Labor Statistics, National Federation of Independent Business
Source: Bureau of Labor Statistics
Source: National Federation of Independent Business
Sources: Bureau of Labor Statistics, National Federation of Independent Business
Source: US Census Bureau
Source: Bloomberg
Source: Bloomberg
Sources: Bureau of Labor Statistics, Bloomberg
Sources: Bureau of Labor Statistics, Bloomberg