The Art of the (less trade) Deal

Mr Trump’s trade war with China is now upsetting the markets. Japan and Korea are in an increasingly acrimonious trade war, too. The UK and the EU are transitioning from single market to WTO. Whatever happened to free trade? Victor Hill inquires.

Washington v. Beijing: No, we don’t hate each other…

Back in late June some commentators thought that the G-20 summit in Osaka would be the moment when the US-China trade spat would finally be resolved. Instead, it has only intensified since then. In the wee hours of last Friday morning (02 August) President Trump announced via Twitter his plans to impose 10 percent tariffs on all Chinese goods not affected by previously announced tariffs from 01 September onwards. $250 billion of Chinese imports into the USA are already subject to tariffs of 25 percent.

China has already imposed $110 billion of retaliatory tariffs of US products entering China. According to the Peterson Institute for International Economics, the average Chinese tariff on US products is now 20.7 percent while the average tariff on other WTO countries is just 6.7 percent. (That should signal an opportunity for British companies to up their game in China.)

The markets tottered last Friday. But on Monday (05 August) the S&P 500 plunged by 2.98 percent and the FTSE-100 suffered its worst day this year falling by 2.5 percent. The Dow Jones was off by 2.9 percent and the NASDAQ by 3.47 percent. There was some recovery on Tuesday but the markets wobbled badly again on Wednesday. The FTSE-100 has lost over six percent over the last week (I write this on Thursday) with an unusual six consecutive days of losses.

The markets reacted on Monday to China’s announcement that it would halt the purchase of US agricultural products by state-owned entities. The Chinese authorities also allowed the yuan to depreciate to the psychologically significant seven-to-a-dollar level for the first time since the financial crisis of 2008. The People’s Bank of China (PBOC) issued a statement suggesting that the lower rate was a response to “unilateralism and trade protectionism”. The presumed strategy is that any additional tariffs on Chinese exports will be absorbed by an equivalent devaluation.

Mr Trump calls this currency manipulation – although, to be fair, the renminbi has been remarkably stable of late when measured against a trade-weighted basket of currencies. The US Treasury declared that China had devalued its currency in order “to gain an unfair advantage in international trade”. However, Larry Kudlow, Mr Trump’s chief economic advisor, insisted that the US still expects trade talks scheduled for September to go ahead.

China’s decision to allow its tightly managed currency to fall to below levels previously defended suggests that the Chinese do not foresee a conclusive trade deal with the US any time soon. They think that America’s real game plan is to starve them of technology and capital. Safe-haven currencies such as the Swiss franc and the Japanese yen gained while 10-year German bunds plummeted to minus 0.53 percent – a new record low.

Numerous US companies are already moving production out of China to other manufacturing hubs in the region such as Vietnam and India. Fears that there could be a mass exodus of capital from China are compounded by the fragility of the situation in Hong Kong where increased political risk is already inhibiting new investment.

America could respond to the Chinese devaluation by using the US Treasury’s Exchange Stabilisation Fund to buy foreign currency in order to drive down the value of the dollar. The Federal Reserve Bank of New York could be instructed to sell off US government bonds from the Treasury’s own reserves and to use the cash proceeds to buy foreign currencies. This would not require Fed Chairman Powell’s imprimatur – the President can order it directly. That would amount to a currency war characterised by competitive devaluations overlaying the existing trade war.

We should also not forget the electoral implications. China’s refusal to buy soya beans from the farmers of Iowa – a state that Mr Trump took in 2016 – could cost him dear in 2020 if they are not compensated. That is no doubt part of China’s calculus.

Tokyo v. Seoul: We don’t really hate each other…

While the US-China trade war has stolen the headlines, trade tensions between Japan and Korea have boiled over in recent weeks. In late July, Tokyo restricted the export of strategic chemicals to Korea which are used, amongst other things, to manufacture computer chips and smartphone screens. Samsung (KRX:005930) cut sales forecasts and announced that it was trying to stockpile chemicals. It is reported that Samsung and LG (KRX:066570) have less than one month’s supply of the chemicals left in stock.

Japan’s action was in response to South Korea allegedly shipping these strategic chemicals to North Korea (something that Seoul denies). But the catalyst for recent tensions was a South Korean court ruling that Mitsubishi (TYO:7211) should compensate Korean citizens for using them as forced labour during Japan’s occupation of Korea (1910-45). Japan claims that all of these issues were settled under the 1965 treaty that normalised relations between the two countries.

Tokyo then announced curbs on exports of hundreds of strategic products to South Korea. In the last week of July a body representing US tech companies wrote to the trade ministers of both countries warning that disruption to supply chains could lead to manufacturing delays. This comes as an unforeseen shortage of computer processors at Intel (NADSDAQ:INTC) has depressed PC production.


One factor in Japanese thinking is Japan’s evolving relationship with the USA. Mr Abe and Mr Trump have met three times this year and they appear to get on well. That said the Japanese fear that Mr Trump will end the long-standing US-Japan security treaty by terms of which the US is pledged to defend Japan against China and North Korea. The Japanese are also nervous about the situation in the Gulf. About 80 percent of the oil consumed in Japan is shipped through the Strait of Hormuz. China has only recently become Japan’s largest trading partner, overtaking the US. All this points to a more assertive Japan – though not one that could take on China.

South Korea is already in defensive mode with the growth forecast suggesting a seven-year low of just 2.2 percent. Korean exports were down 13.5 percent year-on-year in June. But there is more in play there than economic worries alone. In the last week of July demonstrators armed with baseball bats attacked Japanese car brands parked in Seoul. Japanese beer was poured down drains in front of baying crowds. Korean supermarkets have stripped their shelves of Japanese food brands.

Japan threatened in late July to remove Korea from its “white list” of most-favoured trading partners. That would entail that Korean imports into Japan would have to require individual customs clearance. While South Korea ran a trade surplus with the rest of the world of $70.5 billion last year, it ran a trade deficit of $24 billion with Japan. That could be about to get worse.

Washington v. Brussels: Of course we don’t hate each other…

Thus far the EU has remained scrupulously neutral in the US-China trade war. But in the early summer President Trump began a Twitter campaign against the EU. He pointed out that French wines imported into the USA were treated much more favourably that American wines exported to France. (America bought $4.5 billion of European wines in 2017 but sold Europe only $553 million of its own wines.) Then there was the little matter of Spanish olives which Washington argues are subsidised by the Spanish state. They now attract an import levy of 34.75 percent.

Wine and olives are marginal, however. What really matters is how America taxes the import of cars from Europe. The issue has been politicised because Mr Trump is not happy about Europe’s more emollient stance towards Iran. Reportedly, Mr Trump has postponed the decision to impose new levies on European car imports until November. The EU Commission has assured Washington that it will encourage Europeans to buy more US goods. Though Mr Trump is no fool and will regard that promise with dubiety.

America already imposes a tariff of 25 percent on EU-produced steel and 10 percent on EU-produced aluminium. Famously, Mr Trump told Monsieur Macron that he would not stop until Fifth Avenue is cleared of BMWs and Mercedes. Both those German automotive giants have plants in the USA from where they supply not just the US market but China as well. They are therefore extremely susceptible to the US-China trade war.

London v. Brussels: We never really loved each other

If there is indeed to be a no-deal Brexit which will no doubt cause disruption in cross-channel supply chains, it will come at precisely the moment that Europe’s manufacturing powerhouse, Germany, is slowing down. The German automotive sector is being hit by a wave of structural disruption which I shall unpack in some detail shortly. German machine exports have also been hit by the slow-down in China. Overall, German industrial production was down 5.2 percent in the year to end-June.

In late July the influential German IFO Institute revealed that its business confidence indicator went into “free fall”. 80 percent of Germany’s factories are contracting output. Even out-going ECB Chairman Mario Draghi warned that the economic picture in Europe is getting “worse and worse”. He intimated that the ECB might have to cut interest rates again. But critics fear that severely negative interest rates could damage Europe’s ailing banking system further. Some European economists favour fiscal stimulus – but this is out of the question given the strictures of the Stability Pact which binds the eurozone. Even if the ECB could bring the euro down to restore export competitiveness, that might be undone by additional tariffs wielded by America.

Meanwhile the Johnson government’s floatation of the idea of free ports has set tongues wagging in Europe. The idea of designated areas which have favourable tax concessions has been around for a long time – think of the Enterprise Zones like that which regenerated the London Docklands in the 1990s where business rates were suspended for 20 years.

After the now almost inevitable no-deal Brexit (which I will blame on the UK civil service in league with the Brussels mandarinate) the UK will have to pivot towards the US – AND towards China. Since last year, 2018, before Mr Trump started his trade war with China, the UK’s exports to the Middle Kingdom are up by an astonishing 20 percent. British exports to China are now worth £22 billion a year, making China our fifth largest export market – ahead of France.

If Boris & Co. and UK PLC hold their nerve, the adverse effects of the no-deal Brexit could be mitigated within months. We still face brace-position turbulence, however, as I shall explain very soon. Fund managers like Crispin Odey of Odey Asset Management are preparing for the roller-coaster by taking out £300 million of short positions.

Washington v. London: You love us more than we love you

While there has been much discussion of how a beautiful trade deal (as Mr Trump calls it) between the USA and the UK could be easily and swiftly concluded, it is difficult to see what London has to offer that Washington wants. Moreover, given the prospect of a no-deal (WTO if you must) and probably disorderly Brexit, London is the indigent supplicant.

One prominent US business figure pointed out recently: “They [the British] have not done trade negotiations for 46 years”. The former US Treasury Secretary Larry Summers told the BBC this week that the falling pound gives the UK a comparative advantage vis-à-vis the US which America will seek to reverse.


As I foretold two weeks ago in my piece on taxing the tech titans, Mr Trump has now made it clear that there will be no trade deal with the UK if Mr Johnson proceeds with Mr Hammond’s Digital Services Tax which entails a two percent levy on the UK revenues of social media platforms and online marketplaces. Apparently, the threat has been communicated to the UK government “at multiple levels”.

In any case, any US-UK trade deal would have to be ratified by Congress where the Democrats control the House of Representatives. House Speaker Nancy Pelosi has said that the House would not approve any deal with the Brits that disadvantaged Ireland. Frankly, the beautiful trade deal will remain well down Mr Trump’s to do list – below the new NAFTA Agreement and the resolution of the trade war with China. Forget the nonsense around chlorinated chickens: the US-UK trade deal is just not going to happen for years yet.

Hearing secret harmonies…

In classical economics of the 19th century, dating from Ricardo, free trade always implied moretrade and therefore more prosperity. In a zero-sum game, all participants benefit from a level playing field. But in reality, the playing field is never level. That is because there are obvious, visible trade barriers, especially tariffs. And there are much less visible non-tariff barriers which conceal the fact that the game is often slanted by determined counterparts.

May I suggest another perspective from which to view the current Brexit impasse? We are living in an age of counter-globalisation in which those countries which first championed open trading relations are seeking to redress fundamental imbalances that have arisen. The USA is “in a trade war” with China – as everyone knows. Much less prominently, Japan is “in a trade war” with Korea. So, if I were to say that the UK is “in trade war” with the EU, with which it endures a consistent £100 billion deficit – would that shift perceptions?

None of these trade wars will be amenable to overnight signature-and-handshake solutions. For the immediate future trade, for the first time in decades, may grow more slowly than the global economy as a whole.

That is probably one reason why gold has surged to a five-year high of $1,498 an ounce. And with interest rates heading lower the opportunity cost of holding gold is falling.

Meanwhile, the VIX – a measure of expected future market volatility sometimes known as the fear gauge– surged by 33 percent earlier this week to a three-month high. Last week the Federal Reserve linked future interest rate cuts to an escalation in the trade war. This has resulted in further inversion of the yield curve – a harbinger amongst some analysts of recession. With the central banks of India, Thailand and New Zealand cutting rates this week some commentators are talking about a “race to the bottom” via competitive devaluations.

Overall global stock market performance is, like the curate’s egg, good in parts – and decidedly dodgy in others. The Hang Seng, Hong Kong’s principal index has lost most of the gains it made earlier this year. It is down 13 percent since April. There are strong grounds to be cautious.

Geopolitical risk has been rising steadily over the last year. There is escalating tension between Israel, Saudi Arabia and the USA on the one hand and the Islamic Republic of Iran on the other. Iran has taken to impounding tankers in the Strait of Hormuz. The civil war in Syria, though no longer on our screens, rumbles on – as does its twin internecine conflict in Yemen. The situation in Hong Kong could mark the end of one country, two systems – in which case there would be a massive repatriation of capital out of that Asian hub. Tensions are also mounting between nuclear powers India and Pakistan over Kashmir. Venezuela and Ukraine both look highly unstable and could provoke the interference of powerful neighbours…

Meanwhile the global slowdown, which started in China, becomes more apparent. In January the World Bank’s forecast for global growth was 2.9 percent – in late June that was revised down to 2.6 percent. China, the world’s second largest economy, is still growing at an annualised rate of 6.2 percent in Q2 2019. That was down from 6.4 percent the year before. The Chinese authorities are trying to combat the fall-off in export growth by means of additional infrastructure spending. But analysts are already concerned that China’s growth model is overly reliant on debt.

All these things coming together in Q4 bodes ill for global markets. We have entered an age of economic retrenchment facilitated by ever more dazzling technology. Developing countries will seek to sustain their exports through devaluation. Advanced states will increasingly seek to protect themselves before the full impact of the robot-AI revolution is felt across the labour markets.

Thus far, global stock markets have been sustained on the false promise of ever cheaper money supplied indefinitely by the major central banks. I tried to explain that phenomenon a few weeks ago. One day not too long from now that promise will ring hollow – and there will be an almighty market correction.