U.S. - China: China is down, but not out
In its purest form, trade disputes are the mutual infliction of economic damage. It is a battle of attrition – each nation attempts to minimize the punishing economic impact and outlast the other.
The key factor is often economic strength, as smaller nations are less equipped at going toe-to-toe with the global economic behemoths. And therein lies President Trump’s strategy – using the U.S. economy as a hammer.
This puts most nations in a very precarious situation – facing the strength and sheer mass of the U.S. economy. Consequently, Australia, Argentina, Brazil and South Korea quickly renegotiated their trade agreements to more U.S. favorable terms. On July 25, the European Union agreed to begin scaling back its recently imposed tariffs on $3.2 billion of U.S. goods, to buy more U.S. soybeans and liquid natural gas and to reduce other barriers to U.S. products. But even without the European Union’s agreement, its tariffs on $3.2 billion of U.S. products – along with Canada’s $12.6 billion and Mexico’s $3 billion – could be relatively absorbed by America’s $24 trillion economy.
Equally important to its size is the state of America’s economy. It is just not growing, but surging. Now, compare this to the dilemma of our trade adversaries. This year, Canada’s economic growth rate is expected to decline from 3 percent to 2 percent. Mexico’s is expected to hover just above last year’s growth of 2 percent, its slowest pace in four years. In the European Union, economic growth should decline from 2.5 percent to 2.1 percent.
China is a different beast. At $14 trillion, it has the world’s second largest economy. Its economy is essentially dictated by the Communist Party – their leaders don’t face the same political pressures as President Trump. However, cracks are starting to appear in China’s formidable economy.
Until 2015, China was the world’s fastest growing major economy. Much of China’s economy was built not on organic economic growth, but on the mass accumulation of debt. Under the mandate of the Communist government, factories are built, infrastructure projects are green-lighted and goods are produced regardless of need or demand. This production costs money, and the Chinese government has accumulated a mountain of debt to meet its production endeavors.
The size of this debt is reaching critical mass and even the most loyal of Chinese policymakers realize the current pace of debt accumulation is unsustainable. This year, the growth rate for China’s once-heralded “tiger economy” should decline to just 6.5 percent, a 26-year low. Its stock market, the Shanghai Composite Index, has fallen nearly 20 percent.
Fixed asset investment – the investment in construction, machinery, equipment and real estate – grew by just 5.5 percent in the January-July period, the slowest pace since 1996. In July, consumer retail sales increased by just 8.8 percent over the prior year, slightly above May’s 8.5 percent rate which was the lowest in more than 15 years. Industrial production – the value of output produced by manufacturers, mines and utilities – grew by just 6 percent in both June and July, down from this year’s average growth rate of 6.8 percent.
Despite its weakening economy, China still poses tremendous risk and complexity for President Trump. China and the U.S. are each other’s largest trading partners. Last year, the U.S. bought a whopping $505 billion of Chinese goods. For China, the U.S. market accounts for nearly 20 percent of its total exports.
The concern for the financial markets is to what extent the trade disputes will escalate. On Thursday, the U.S. and China will each impose tariffs on another $16 billion of each other’s products, bringing the total to around $53 billion each. But what if this total then goes from $50 billion to $100 billion, or $200 billion, or even higher, as both sides have threatened? Almost overnight, American companies will go from a level of tariffs they can gradually absorb to a level that drastically impacts their profitability.
Yes, China’s economy is faltering, yet it is ill-advised to think its leadership will suddenly capitulate to America’s trade demands. However, it increasingly raises the prospect that China will be forced to give greater leeway at the negotiating table. And that’s all that may be needed to settle this trade dispute.
Mark M. Grywacheski, Investment Advisor
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Quad Cities Investment Group, LLC is a registered investment advisor with the U.S. Securities Exchange Commission.
