June 2019 - Special Market Update

The Trade War is Real

During the month of May the U.S.-China trade war negotiations fell apart, after China walked back on several key points in what many experts describe as the 9th inning of consummating a trade deal. This followed weeks of reports from White House sources that a deal was "imminent". In a swift response to the Chinese pushback, tariffs have been increased with the threat of more to come. A fix is still possible, with Presidents Donald Trump and Xi Jinping set to meet at the G-20 summit in June. However, at this point, it looks more likely that the trade war will be long, messy, and expensive.

Through the People's Daily, the official newspaper of the Communist Party of China, China explicitly warned the U.S. recently, saying:

"We advise the U.S. side not to underestimate the Chinese side's ability to safeguard its development rights and interests. Don't say we didn't warn you!"
The phrase "Don't say we didn't warn you" has only been used two other times by the People's Daily in history — in 1963 ahead of China's border war with India and in 1987 right before China went to war with Vietnam.

If tariffs expand to cover all U.S.-China trade, and markets slump in response, global GDP will take a $600 billion hit in 2021, the year of peak impact. Bloomberg economic modelling suggests that "output in China and U.S. would be lower by 0.5% and 0.2% respectively, relative to a no-trade-war scenario."

On May 5th, the trade war reached its crescendo as Trump tweeted that he intended to raise tariffs on $200 billion of Chinese goods from 10 percent to 25 percent on May 10th. Subsequently, the threatened tariffs did indeed rise after Washington and Beijing failed to reach a long-sought trade deal despite days of intense talks.

Retaliation was swift. On Monday, May 13th, China announced it would increase its own tariffs on $60 billion of American wheat and soybeans, severely affecting American farmers. Around 5,000 items will now have duties increased up to 25 percent as of June 1st, according to China's finance ministry.

There are signs that things could soon get even worse: The Trump administration is considering upping tariffs on all of China's remaining imports — about $300 billion worth of products.

These latest moves make two things perfectly clear. First, the two countries are not close to striking an accord that would see China modify some of its trade laws in exchange for tariff relief from the U.S. Second, Washington and Beijing could soon have little to no free trade between them — stunting the global economy and increasing prices for consumers and importers in the U.S.

Just how much this will affect global economies is uncertain. Both countries are in uncharted territories. We believe it is in both countries' interests to find a resolution. However, China has one tactical negotiating advantage: China wants to portray itself as playing the long game in the trade battle in contrast with President Trump, whose reelection next year could be at risk if voters perceive the trade war negatively. How a newly elected Democratic President would handle this trade impasse is anyone's guess.

But why are we fighting? And are the economic consequences of the fight worth it?

Once the U.S. formally recognized the People's Republic in 1978, American businesses were tantalized by the prospect of China's untapped market of 1 billion consumers. What American companies soon discovered, though, was that this trade partner did not play by the accepted rules.

The single best example of this disregard for rules remains McDonald's experience in the mid-2000's. The Beijing municipal government broke the company's 20-year lease after just two years and effectively evicted McDonald's from its flagship, three-story, 700-seat restaurant in the heart of the capital to make way for a massive shopping complex. As a U.S. news report at the time said, "the dispute has come to epitomize an entrenched Chinese notion that terms of contracts can be altered at will."

The facts are clear, China's repeated and unashamed theft of intellectual property has been especially egregious and damaging. A 2017 report by the independent and bipartisan U.S. Commission on the Theft of American Intellectual Property put the annual cost of IP theft by all parties at $255 billion to $600 billion in counterfeit goods, pirated software and stolen trade secrets; these figures do not include the full cost of patent infringement. The Commission named China "the world's principal IP infringer."

In fact, Kevin O'Leary, of Shark Tank fame, has repeatedly laid out examples where products he partnered with on Shark Tank were brought to China for manufacturing and production. Many times, even before the company received their initial production order, multiple knockoffs would surface on Amazon and Alibaba. Since it is not possible to litigate against Chinese manufacturers, there was no real recourse in these circumstances. O'Leary stated that innovative U.S. ideas and inventions are flat out stolen everyday with the Chinese not even hiding the fact. In fact, O'Leary calls it the "Chinese business model". He has been an outspoken supporter of President Trump in his battle to get China to "play fair".

A now-emboldened China is pushing its "Made in China 2025" campaign, an ambitious plan not only to upgrade Chinese industry — most notably in advanced sectors like information technology, robotics and pharmaceuticals, where IP is key — but to compete with and ultimately displace foreign companies domestically and globally. To that end, it has continued to aggressively push foreign companies to hand over technology and IP rights in exchange for market access — a possible violation of WTO rules.

The one thing that most Americans believe is that trade with China has been unfair for decades. Until now, no previous administration has shown the determination to tackle the issue. Trump's approach, while unpalatable to some and unsettling in the short term, could result in a much-needed new chapter in U.S.-China trade, one in which Beijing can be compelled to abide by the rules it agreed to when it was granted WTO membership. If nothing else, Trump has unequivocally called China out for behavior that should not be tolerated, and paved the way for other nations to do so as well.

The United States remains the one player that can effectively challenge China's unfair practices. Trump's tariffs have set the stage for policymakers, trade negotiators and China experts to develop a U.S.-led, worldwide strategy that is clear, forceful and has teeth, even if it means short-term economic hardship at home.

We are monitoring the situation closely on your behalf and, as always, continue to take a disciplined long-term investment approach. If you have questions or concerns about the trade war's impact on economic markets, do not hesitate to call or email.


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