Trade policy and the US-China relationship

19 April 2017 | Markets and Economy


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Changes in United States trade policy under President Donald Trump and the possibility of a "hard landing" in China loom over economic forecasts. Joe Davis, Vanguard's global chief economist, shares his insights into how US-China relations could affect the international investment landscape.

Lara de la Iglesia (moderator): I actually want to move then to a question that's on a lot of folks' minds, given the new administration and some discussions. How do you think the potential for changes to trade policy may affect things?

Joe Davis (Vanguard global chief economist): I think it's very likely we're going to see changes in trade policy. That's one. Two other points I'd have is – one is, I don't think the markets are reflecting enough of the distribution of risk. So I think the market, generally, is looking at the positives with respect to potential fiscal stimulus [in the US], infrastructure, corporate tax reform, all of which we may see over two years. But there's risk on both sides and particularly with the negative skew on the trade measures, and that's not reflected in asset prices. That's, I think, the near-term risk, in my mind.

I think part of what we're seeing is talk. I think what we will more likely see is bilateral greater negotiations. NAFTA, by our analysis, has to be adjusted regardless of who's the [US] administration. And we've seen a general modest rise in protectionism across the world the past two or three years. What I think we will see is more serious trade discussions between the US and China over the next year, so more in a bilateral fashion – same way with Mexico – rather than a multilateral agreement.

Lara de la Iglesia: I actually have a live question that's come in from Jeff on China. "How much concern do you have regarding China's potential selling off of US Treasuries?"

Joe Davis: It's a fair question. I think the relationship between the United States and China is the biggest risk factor, in my mind, in the markets and the economy for the next five years.

Lara de la Iglesia: One of the four that you've listed with —

Joe Davis: One of the four listed, and everything else is a distant second. And when I look at tail risk, and it's not all bad. But should we proceed with more significant trade sanctions aimed at China, which is a hypothetical, but it could very well happen, you could anticipate retaliatory effects.

Where it gets a little messy is what China has done in the past, and they're not the only country. Should that occur, there's been things outside of tariffs and so forth, so you can do things domestically. Selling off of Treasuries is one. I think that's one of the areas we probably would see less because there's a symbiotic nature. In other words, if one is – in a sense, purely hypothetical – if one is in the environment where it's a tit-for-tat and it's more punitive measures, that measure, it's a scenario where they're selling US Treasuries, that hurts their own balance sheet and their foreign reserve, so I would put that lower on the list.

There would be other things, such as making operations of doing business if you're a US company in China much more difficult, either through operations – they've done everything to bans on certain products. So you could see other measures that would effectively undercut the apparent support for that measure to begin with. I would anticipate, should that ever play out, it would see that less so than a selling of US Treasuries.

Either way, I think, in that environment, the US interest rates are lower because bond prices have risen given the inherent global uncertainty that is causing in global markets.

Lara de la Iglesia: Let's stick with China for a minute, and let me ask you a follow-up question. They have a big job in trying to stay away from a hard landing, engineering a soft landing. Can you give us your perspective on where China is with that right now?

Joe Davis: There are hard-landing concerns – and hard landing meaning effectively a recession or, by their growth estimates given [the] population, dropping below, say, 3% or so growth. And they're growing officially around 6.5%. Our indicators have suggested for some time they've been growing 4.5% to 5%. So although that is true, we don't believe there's a high probability of a hard landing, [and we haven't] since those concerns surfaced four or five years ago.

The longer out we look in terms of China, the more pessimistic we are relative to consensus. The general consensus is China will continue to rebalance. I mean, more than 50% of their economy is consumer now, so they've done a good job. But imbalances are growing significantly. Corporate debt and leverage have risen significantly. There's been effectively no reform on state enterprises.

And so the risk China has is actually not allowing their currency to float four or five years from now. And I think if there is a risk, [it] is that China's fear of the business cycle, fear of recession, and then delay in reforms is their greatest risk. Because what happens is you become effectively a poorer version of Japan, where you have very high debt levels, but you haven't escaped the middle-income trap.

That's not our baseline, but we put the odds as high as, I don't know, one in three. That is not tail risk anymore. That is something that we are monitoring closely. It is not something I think we will entertain more significantly in 2017. So we're not as bearish near term, but longer term, it's an area that we hope to see greater progress. China knows what to do, to give them credit, but that's an area of the world that we're a little concerned about.

Lara de la Iglesia: And continuing to monitor and focus on.

Joe Davis: Continuing to monitor and do deeper analysis on.

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