October 14, 2018

 

2018 Q3

Overview & Outlook

In Q3 2018, we’re going to take a deeper dive into the US-China situation, briefly review the USMCA trade agreement, and review some key points about the Yuan.

 

USA and China

It's Q3 and President Trump continues to enforce additional tariffs onto Chinese exports. Though there is much speculation on the motive for implementing tariffs, my view is one that ties back to natural human instinct - President Trump's goal of maintaining power and control within the US.

 

Here is short refresher on recent history:  For as far back as most of us may remember, the US has been the dominant global nation, and with that came a myriad of benefits ranging from USD reserve currency status (which allowed the US to run huge deficits to fund their own growth), interest rate control (which gave them power over capital flows in and out of their country), to military power (brute force, intelligence gathering, and status), and much more. In the past decade, however, we’ve seen China grow immensely from a poorer developing country that was barely a competitor for the US to a global powerhouse that has the US scrambling to maintain control. China has grown at such an immense pace that we’ve seen a large group of American companies outsource tremendous amounts of work to China, as labour is remarkably cheaper there. Additionally, due to China's immense population, US companies grew a desire to sell their products in China too - so these US companies could grow their revenues.

Now, in order to manufacture and sell to China, China required US companies to disclose their own intellectual property (the patents and technologies that are proprietary to US companies) to the Chinese government; and only then would the US companies be allowed to sell to China. This, as a result, allowed Chinese State-Owned enterprises to access limitless proprietary American innovations and technologies, which eventually found their way into the hands of Chinese manufacturers. It wasn't before long that the proliferation of technological developments in China allowed them to begin competing directly with the powerful technologies of the US.

 

Coming back to where we are today, both China and the USA having become largely interdependent, relying on one another - but China seems to be reaping more of the benefits as they are growing faster than the US.

Now for my view… for the US to protect its power, growth, and independence, it will need to get its American companies to stop giving business (and intellectual property) to China. One way of doing this is to impose tariffs, hoping to disincentivize American companies from producing in China as it becomes more expensive. While this does prove to work, making American companies want to pull out of China - if it gets too expensive, there’s one key factor that China has control over to combat the effect of these tariffs. And it's their currency: the Yuan.

 

In the last quarterly report I pointed out how the Yuan has begun devaluing immensely against the US. And though the picture wasn't completely clear then, it is becoming so now. As President Trump imposes tariffs that makes exports 10% more expensive in USD terms; leading American companies to want to manufacture less in China. However, by the Yuan devaluing by 10%, that means everything in China is 10% cheaper for the US to buy in USD terms. In short, tariffs increase prices by +10% and Yuan devaluation makes prices decrease by -10%, which thereby effectively reduces or even nets out the effects of many tariffs.

USMCA: The 'New' NAFTA

To put this one simply, Canada seems to come out ahead here on the free trade agreement. With our country's extreme dependency on free trade with the US, it was critical that we maintained the agreement. However, the fear was at what cost - what would the US want in return?

 

Well, Canada had to give up some of its protection for our dairy farmers from US farms that would sell dairy in our Canadian markets and put some of our dairy farmers out of business. The other major part of the deal is about tariffs on automobiles. If Mexico or Canada build automobiles where 25% or more of the components come from countries not in North America, then USA will charge tariffs. If however, 75% or more of the automobile components originate in North America, then those automobiles can be shipped to the US tariff free.

 

In short, we avoided a major Canadian economic problem that could've severely damaged our country's growth, by simply ensuring to the US that more auto parts originate in North America, and that we will allow the US to sell us more dairy. So as it stands now, I think we got the better end of the deal.

 

Something else here worth mentioning is that Mexico's minimum age for auto workers has nearly doubled, from $8/h to $16/h as per the new agreement. Suggesting that vehicle production cost from Mexico is bound to increase.

 

Finally, just to note, that unless there are large changes during the ratification of the agreement some time in Early 2019 - this agreement doesn't seem like it'll have any major impact on the USD/CAD FX rate.

Final Thoughts

With the new NAFTA out of the way, the pressure now falls on Europe and China to "strike a deal" with USA. While Europe seems to be having trouble of it's own, we may see President Trump move in to impose tariffs on autos and select other goods. As far as China goes, I think we'll see continued pressure with tariffs and retaliation with potential further Yuan devaluation. And all while in the backdrop we see significant devaluations in other emerging market currencies, which I mentioned would likely happen due to mounting USD denominated debt in these emerging markets. Also as I mentioned in the Q2 2018 Report, we're in a market where to succeed, you need to be a bottom-up stock picker; while emerging markets slowly crumble there will be some great buying opportunities and left standing in the debris will be a handful of extremely valuable companies to own.

Something Worth Noting

China looks to be headed into a bear market. It's something I have my eye on, and will continue to watch closely as they too have unprecedented debt levels. In the mean time, we may see capital flood over to US treasuries as a safety trade - perhaps expect the US dollar to hold its strength because of this.

Thanks for reading.

Your Financial & Investment Advisor,

Gianluca Folino