This is part of an ongoing series of articles published by Johnson Financial Group. This issue is written by Brian Andrew, EVP, Chief Investment Officer.
In the last several weeks, most of my conversations with clients have been about China, trade and bond yields. The three topics are interrelated and something we spend a lot of time discussing to determine how each could impact our investment decisions. Of the three, the most important is China, because policy decisions made there and here are of great significance to global investors across all asset classes.
At over $14 trillion, China is the second largest economy in the world. Go back and read that sentence slowly. The U.S. is number one at over $21 trillion. In short, that is why the Trump administration has taken them on in trade. Over the last two decades, China has become the world's manufacturer. This required a substantial investment in manufacturing capability, the infrastructure to move products from manufacturing hubs to ports, and the training of tens of millions of people for skilled jobs. This chart shows their share of the world's exports – you can see how their role grew over time.
In order to accomplish this, China has moved more than 400 million people into an urban environment, quickly, creating the largest “middle class” (in numbers, not per capita income) in history. This move has required an enormous amount of infrastructure spending on roads, bridges, rail, housing, ports and airports. For many years, the growth rate in China was the only thing that mattered to commodity prices. As China's growth rate has slowed, they have become focused more on their domestic economy and growing the consumer contribution to growth (remember that economic growth or gross domestic product growth is equal to consumption + investment + government spending + net exports). The chart below, which shows the real GDP growth rate for China, illustrates the slowdown.
As the middle class in China has grown, so has their demand for higher wages. Thus China's advantage as the world's manufacturer has begun to wane.
As China's economy grew in size, their desire to have a more prominent role on the international stage grew with it. What happens when an economy goes from below number six to number two in 20 years? They butt heads with number one. China has long had a desire to have more influence in Asia. More recently, they have increased their appetite for African raw materials. They have been striking deals with governments across the continent, exchanging their engineering and trained labor to build infrastructure for access to those materials not available in China. In addition, they've been using African land to improve their production of agricultural products for consumption at home.
China embarked on two programs in the last five years that have a global impact and are specifically designed to raise their profile. The first is the “Belt and Road” program. While mostly described as an infrastructure program to reconstruct the Silk Road of trade from East to West, it is more far reaching. The program has become a catch‐all for other things that include Chinese student foreign exchange programs, foreign engineering initiatives and placement of Chinese scholars in foreign higher education facilities. These programs provide an opportunity for China to have a more meaningful global impact and compete with the largest economy in the world – the U.S.
The other program, released in 2015, is “Made in China 2025.” By their own admission, this is an industrial policy that seeks to make China dominant in global high‐tech manufacturing. (Industries include robotics, telecommunications, electric vehicles, next generation IT and artificial intelligence.) “The program aims to use government subsidies, mobilize state-owned enterprises, and pursue intellectual property acquisition to catch up with and then surpass Western technological prowess in advanced industries.” (Council on Foreign Relations, May 13, 2019.)
China has a track record of taking intellectual property from companies in exchange for access to their market and consumers. Many U.S. and global brands have openly done this in order to access that market. However, with the growth of their middle class, the program aims to move more of their workforce away from mining, energy and consumer goods and transfer it to high‐tech.
These programs are mentioned to emphasize the effort on the part of China to become a more meaningful global player. In the interest of paper and space, we won't go into the details on the geo-political impact of such efforts.
We can now refer to the trade dust-up with China as a trade war. The Trump administration has taken aim at China's policies and decided to use tariffs, the only weapon available to the administration without the approval of Congress, to try to improve the U.S. trade deficit with China.
Remember that formula above about economic growth? At the end of it is net exports. When that's negative, it detracts from an economy's growth. The U.S. has a negative $650 billion or so in net exports. This means we import more than we export. More than half of that trade deficit is with China, a result of them becoming the manufacturer to the world.
Given China's determination to have access to the world economy and the U.S.'s determination to hold on to its current number one spot, we believe we are at the beginning of a trade war. Even if a deal is consummated in 2019 or 2020, it will likely be modest because the geo‐political impact of these trade policies is broader than the volume of goods/services being traded. From an investor's perspective, then, we need to think about the long‐term implications of trade on portfolios.
We start with the impact on the global companies we own. More than half of the revenue from the companies included in the S&P 500 Index come from overseas sales. That means they have global customers and supply chains and are most impacted by the trade war. Tariffs on their products and raw materials raise their costs and they must determine whether those can be passed on to their customers or removed by relocating their supply chain.
As an example, if you make a refrigerator that requires a computer chip made in China, and that chip has a 25% tariff imposed on it, then the cost of making the refrigerator is higher. You can either increase the cost of the product to consumers or find another country where that chip is made that doesn't have the tariff. Better yet, if you could find a place in the U.S. where that chip is made, you'd alleviate the problem entirely. Wait – if you sell refrigerators all over the world, then other countries may have similar tariffs on U.S.‐made goods and you'll still have the same problem. Suffice to say, the problem is very complicated for global companies.
We're beginning to see a shift in supply chains. As the trade war with China heats up, companies are looking to move parts of their supply chain to countries like Vietnam, Indonesia and India. However, they don't have the skilled labor, manufacturing capacity or innovation that now exists in China, so the transition will take time and cost money, hampering earnings.
As a result, we, along with the investment managers we employ on our clients' behalf, will continue to analyze the impact on these global companies' earnings, cash flow and debt levels. As a result, our allocation to them may change. Because we are global investors, we will also continue to identify those companies benefitting from China's consumer growth and investments. Owning companies like Baidu, Tencent and Alibaba, all of which compete successfully with Amazon, Microsoft and Google, makes sense in a diversified portfolio.
Of course, because China is the world's manufacturer, any change in policy there or abroad has far‐reaching implications. If the second largest economy slows, then the world will see a decline in growth. If supply chains are moved, reducing investment in China, world growth will slow. In an environment where the aging of the developed world's workforce has already caused a decrease in the global growth rate, this matters more.
For the last 10 years, the average rate of real economic growth in the U.S. has been 2%. That's a little less than half the growth rate in the 1990s. When growth slows, the country's central bank, the Federal Reserve, likes to reduce the cost of borrowing to get people and businesses to spend more. As a result of its concerns about the lower rate of global growth spilling into the U.S. economy, the Fed lowered rates for the first time in more than 10 years last month.
Bond investors took this opportunity to bid up bond prices and force yields lower. They are trying to send a message to the Fed that the economic slowdown could be more dramatic and the Fed needs to lower rates further. With a 2‐year Treasury yield near 1.5%, the market suggests the Fed Funds interest rate is 0.75% higher than it should be.
We have been saying for some time that we believe interest rates will remain low due to low growth and inflation. The recent rally in bonds suggests that environment will continue.
It is important to note that bond yields are half of what they were in October of last year. Normally, the Fed begins to reduce interest rates after growth has dramatically slowed, which leads to lower interest rates. This time around, rates have fallen before the Fed's action. That means the beneficial effect of lower rates has already been around for eight months.
Although yields are low, we remain committed to our bond positioning. Bonds remain a sound diversifier to equity exposure and produce good total returns in this environment. We also note that the yield advantage from corporate debt remains near the lowest levels seen in the last five years. If bond investors were concerned about companies' ability to pay, that would not be the case. (A counterargument to the recession din from pundits.)
As it relates to a recession, we've had two intra‐economic recessions in the last 10 years, mostly within manufacturing, with the last taking place in 2015. This seems to be the situation again. While trade tariffs have a negative effect on growth, the current and proposed tariffs suggest a negative effect of nearly 1% on growth, perhaps cutting it in half but leaving it positive. This remains our view today.
China will continue to dominate the conversation among investors for many reasons, including this administration's focus on changing the trade game, the size of their economy and its effect on global growth, their desire to become a more dominant global player, and the need to turn to consumerism at home. Our investment process provides us with a global perspective on asset value and includes conversations with some of the best global investment managers whose perspective we use to make our portfolio decisions. We view the volatility in asset prices from the China issues as an opportunity. Our risk management processes provide information about how much risk we're taking and the impact of the changing environment. Taken together, we believe this suits us well in an environment where China will impact much of our decision making.
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