The US/China trade war is bad news for markets, but China’s faltering consumer and overheated property markets could really raise the pressure.
Investors have shifted their expectations at the start of the year from one of synchronised global growth to a realisation that economic prospects are increasingly diverging. The potential impact of a global trade war is influencing investor sentiment, but so too are monetary policy expectations, particularly in the US. However, and not for the most obvious trade-related reasons, it is what is happening in China today that investors ignore at a potentially high cost.
First, a quick look at what the central banks are up to. The European Central Bank has reassured investors in eurozone debt markets with its pledge to maintain zero-bound interest rates until the summer of 2019. Despite recent soft economic numbers, the ECB still plans to end its quantitative easing programme by the end of 2018. But poor growth figures have been weighing on stock market indices – mainly due to the high weighting of eurozone banks, which have been mired in a bear market (defined as a fall of more than 20 per cent from a 52-week high) since the start of the year – with few signs of a respite.
In the UK a better-than-expected outcome for growth in the first quarter, along with a 5.1 per cent rise in consumer spending in June, increasingly points to the prospect of an interest rate rise in August. The Bank of England is in the last-chance saloon, or very close to the swing doors at least. Raising rates beyond 0.5 per cent in August gives it some wriggle room in the event of a poor outcome to Brexit negotiations and/or the fall of the government.
Both these monetary and political outcomes will hit the value of sterling, and by association the FTSE 100: the international nature of the index means that the index benefits when sterling falls, and vice versa.
In the US, the Federal Reserve continues to telegraph steadily rising rates over a year and beyond. It has already raised its Fed Funds target rate twice this year to 1.75-2 per cent, and two further rises are expected to take it to 2.25-2.5 per cent by the end of 2018. Longer term, the median range on the Fed’s ‘dot plot’, which tracks the expectations of members of the rate-setting Federal Open Markets Committee, suggests that rates will rise to around 3 per cent. However, the danger of the Fed being forced to react to an overheating economy, thanks to president Trump’s tax-cutting stimulus package, means rates could move as high as 3.5-4 per cent by 2020, the dot plot suggests.
That would be great for savers and bad for equity and bond markets, as investors move money into cash, which for so long has provided little in the way of a real return. But the economic damage of an escalation in the trade war between the US and the rest of the world, but principally China, could kick those higher rate expectations into touch.
However, it is events in China, the world’s second largest economy, that we should be watching closely in coming months. Some China-watchers are seeing parallels with the country’s 2015 currency and stock market crisis, which rippled out into global markets.
In June the Chinese renminbi suffered its largest-ever monthly fall against the dollar, a trend that continued into early July. Stock markets have also been heading south: the Hong Kong Hang Seng index is down 9 per cent in the month to 10 July and the mainland Shanghai SE Composite index has fallen by more than 10 per cent, putting mainland markets firmly into bear market territory over the past year, along with the funds that track these indices (see chart).
That China will be the biggest loser in a fully fledged trade war with the US is the ready explanation for the recent drop in its currency and its markets. It has retaliated against the 25 per cent tariffs that the US imposed on £34 billion worth of China’s exports to the US in early June, following earlier US restrictions placed on imports of solar panels, aluminium and steel. Now Trump has responded with plans to slap a 10 per cent tariff on $200 billion (£151 billion) of Chinese goods annually. Failing the negotiation of a peace deal, they could take effect following the conclusion of consultations at the end of August.
The threat to China’s exports, and the firms most exposed to the imposition of further US tariffs, is obvious. However, Freya Beamish, chief Asia economist at the consultancy Pantheon Macroecomics, says: ‘In terms of the direct impact, the drag on Chinese GDP would be minimal. But if China retaliates, this would damage private consumption as well.’
The importance of China’s domestic consumption growth cannot be overstated: in the first quarter of this year, it accounted for almost 80 per cent of the country’s overall economic growth. That shows how far it has come in its efforts to rebalance away from a wholly export-oriented economic model.
Following the currency and market woes, the potential for private consumption in China to fall further is a triple-whammy of bad news, particularly for highly indebted companies in China and other Asian and emerging market countries in the country’s supply chain. First, rising US interest rates and a dollar that has appreciated by around 8 per cent this year mean firms that have borrowed in dollars face a punishing repayment schedule. Secondly, there is a growing shortage of said dollars in which to refinance debt, because so much of the global dollar stock is being repatriated back to the US.
It is not only Asian corporations that are vulnerable to falling domestic demand in China. It has been one of the big investment themes of the decade. Many European fund managers, for example, highlight big exposures to higher-spending, younger Chinese consumers and businesses at the expense of their faltering, ageing European counterparts. Plenty of US and other global businesses have also developed a big presence in China.
The (admittedly short-term) fall in Chinese retail sales growth illustrates the point, down to 8.4 per cent in May from 10.1 per cent in March, according to Trading Economics. The upshot is that if the rate of domestic consumption growth continues to falter, the tremors will be felt far beyond the Asia-Pacific region.
Parlous property market
However, there is another long-running problem in China that could fuel the flames of a China-led crisis. Three years ago the overheated property market was a concern for investors. They should be more worried today.
Inflating prices have mushroomed out from big cities such as Shenzhen and Shanghai, which have underpined China’s domestic growth. The authorities are finally dampening demand, but even a 10 per cent across-the-board correction in property prices could do serious economic damage. As part of the country’s broader ‘deleveraging’ strategy, consumer credit has also become more difficult and expensive to access.
The People’s Bank of China could loosen monetary policy to offset weaker consumer growth and the implications of the trade war. However, producer price inflation in June rose at its fastest pace for six months to 4.7 per cent. Moreover, the central bank will be mindful of further stoking the overheated property market. ‘When the US sneezes, the world catches a cold,’ goes the old adage. Perhaps that should be updated to ‘when China coughs, the world risks contracting pneumonia’. But the carrier of the contagion is not only Donald Trump.