Investors are growing afraid
That things will get worse in re trade
In Shanghai they’re shaken
With stocks there forsaken
At home, market bulls are dismayed
For the time being, there is only one story that seems to matter, the brewing trade war. Rhetoric is heating up on both sides of the Pacific and concerns are growing that what initially seemed to be a negotiating position by the US is morphing into a firm stance. It is becoming increasingly clear that President Trump believes that he can ‘win’ a trade war, and that China will suffer much greater harm in a much shorter time period than will the US. And despite yesterday’s equity market decline at home, the story in China remains significantly worse as evidenced by the Shanghai Index, which has now fallen more than 20% since January. At the same time, we continue to see the Chinese yuan suffer on a daily basis, with last night’s decline of a further 0.6% taking the movement over the past week alone to nearly 2.0%.
It can be no surprise that the CNY continues to weaken, as the currency remains the main safety valve for the Chinese economy. China is still mercantilist at heart, and the competitiveness of its exchange rate is a crucial factor in economic growth. As I mentioned yesterday, the PBOC’s key concern is that excessive weakness in the yuan will result in significantly more capital outflow than desired, which will in turn weaken the yuan further and potentially cause a more negative stock market reaction. We saw this occur in August 2015, and then to a somewhat lesser extent in January 2016, and both times the government’s response was to tighten rules restricting capital flows. While those tighter rules remain in effect now, if we see a more accelerated decline in the currency, look for yet another wave of regulation there to prevent further damage. It is, of course, somewhat ironic that as President Xi tries to appear as an internationalist in certain forums, his immediate response to a market hiccup is to close off access to investors, both domestic and foreign.
But CNY is not the only currency impacted by the current narrative. In fact, the entire emerging market space is under pressure with month-to-date declines in KRW (-4.5%), THB (-3.1%), MXN (-2.1%) and CAD (-2.6%). Well, even if Canada is not actually an emerging market, it has clearly been hampered by the trade story and NAFTA. And arguably, that is the driving force across all currencies right now.
Which nations will suffer the most if the global trading framework that has been developed over the past 70 years comes undone? It will be those nations where trade represents the largest share of the economy. A quick look at World Bank data from 2016 on the subject shows that Luxembourg is atop the list, with trade representing >400% of GDP followed closely by Hong Kong (373%) and Singapore (318%). While those are extremely high numbers, heading down the list shows that almost every EU country comes in above 100%, with even mighty Germany at 84%. Meanwhile, the US sits at just 27%. If you wonder why President Trump believes the US can win this ‘war’, it is because of data like this. The US retains the ability to be self-sufficient in almost everything, something that no other nation on the planet can boast. And while it would be inefficient and drive inflation higher, it seems pretty clear that the administration is going to push this envelope as far as it can. So be prepared for the trade story to dominate the headlines for the next several months, especially if US economic data doesn’t falter. And ironically, despite the fact that a weaker dollar would be more beneficial to the US in this case, look for the dollar to continue to outperform.
As to the rest of the FX market, the dollar has stopped its recent corrective decline and has rebounded this morning across the board. There has been vanishingly little data to absorb, and so my sense is that we are merely watching the trade story rhetoric play out. Yesterday’s New Home Sales data was quite strong, but that remains a relatively small sector of the entire housing market, and so is not the best descriptor of the economy. This morning’s data includes Case-Shiller Home Prices (exp 6.8%) and Consumer Confidence (128), neither of which should be too impactful. Rather, market players in every market will continue to watch the tape for the latest trade news and try to determine whether things are still heating up or whether the rhetoric has peaked. If pressed, I would say we are not close to a peak, and that this story has real legs. As such, I think the dollar will continue to be the main beneficiary for the time being.