Quarterly Market Update

Q&A

Q&A with Chief Investment Strategist for BBVA Compass Global Wealth Dan Davidson, CFP and Chief of Equity and Alternative Investments for BBVA Wealth Solutions, Anne-Joëlle Viguier-Galley, CFA

In this edition of the BBVA Compass Market Outlook, we examine some trade issues and try to separate noise from facts.

1.  Tell us about some historic facts.

In 1947 the General Agreement on Tariffs and Trade (GATT) was signed in Geneva between 23 nations. This legal agreement intended to promote international trade by reducing or eliminating trade barriers such as tariffs or quotas. It remained in effect until 123 nations signed the Uruguay Round Agreements in 1994 which established the World Trade Organization (WTO) on January 1, 2015.

Applied tariffs on industrial products have approximately halved since the mid-1990s to a simple average of 5.5% across all countries as shown in the table below from the OECD Economic Outlook. However, the average WTO Most Favored Nation (MFN) bound rate, i.e. the negotiated maximum tariff a country can levy on a non-discriminatory basis on imports from another WTO member, is roughly five times as high. (26.2%). The difference between applied rates and WTO bound rates is similar for OECD countries, yet the percentages are lower (2.2% vs. 11.2%).

2.  Why is this important?

It is important because trade agreements helped to lower tariffs. The implementation of the Uruguay Round Agreement ended in 2004 with more tariff reductions being implemented through preferential and regional trade agreements. Simulations of multilateral and regional trade agreements with the OECD METRO Model (OECD, 2018b) show that positive effects are higher when more countries participate in trade negotiations.

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Stock Market Returns in the Last 5 years

3.  What does global trade look like now?

This is the perfect time to use the expression “A picture is worth a thousand words.” The graph below highlights how “advances in communication technologies and the reduction of trade barriers in the last 20 years have facilitated the expansion of Global Value Chains (GVCs), with large shares of manufacturing being moved from the G7 economies to selected Emerging Markets’ Economies (EMEs), notably China and South East Asia, Mexico, and Central and Eastern Europe1 .” The relative importance of the G7 countries in global trade, and bilateral trade flows between them, has declined, while the relative weight of China has increased. Non-OECD economies now account for roughly two-fifths of world trade, from less than one-third in the decade after 1995.”

4. Why do you say that trade “issues” or “stumbling blocks” are not totally new?

Actual figures show that since the financial crisis, global trade has been subdued (see graph below). The OECD notes that the number of new trade restrictions in the major economies has built up in the last decade. This may be due to the actual financial crisis of 2007, which pushed countries to try to “protect their own” or it could be related to the ascendance of newer digital technologies and services such as big data, the “cloud”, artificial intelligence, robotics, 3D printing etc., all of which may reduce offshore production and global trade further; indeed, some production can return to developed economies at the lower cost associated with these new tools and know-how.

Stock Market Returns in the Last 5 years

5.  What about non-tariff measures (NTMs) and services’ trade barriers?

These are important as services generate more than 2/3rds of GDP in advanced economies (OECD, 2017d). “Non-tariff measures (NTMs) comprise all policy measures other than tariffs and tariff-rate quotas that have an effect on international trade by influencing the price of traded products, the quantity traded or both. Generally, these relate to regulations that aim to achieve policy goals such as reducing information asymmetries or reducing risks for humans, animal or plant health. These also tend to increase production costs and can affect the development of new technologies.”

6. Can you summarize where we are now?

According to the current administration, “…the Chinese government uses foreign ownership restrictions…to require or pressure technology transfer from US Companies to Chinese entities…the Chinese government uses its administrative licensing and approvals processes to force technology transfer in exchange for the numerous administrative approvals needed to establish and operate a business in China2 .” Prior to the financial crisis China’s position was mostly that of an export oriented trade model. Lately though, it seems that Chinese tech firms and the Chinese government saw the possibility to boost their high tech industries by attracting international investors and creating benefits for domestic Chinese companies. This strategic plan, called “Made in China 2025” was issued by Premier Li Keqiang and his cabinet in May 2015. It is described as an initiative to comprehensively upgrade Chinese industry directly inspired by the German Industry 4.0.3 On June 26, 2018, US President Donald Trump began working with members of Congress to update existing legislation in order to ordain the President with the power to limit foreign investments, namely investments from China in US tech companies.

On March 22, 2018 the office of the United States Trade Representative (USTR) issued its report listing grievances against the Chinese government’s unfair trading practices and prompting President Trump to announce tariffs on US $60bn worth of Chinese imports. On April 3rd, China announced retaliatory tariffs and this was met with the Trump administration publishing a list of 1,333 products being considered for a 25% tariff covering around US $46.2bn in imports. The Chinese government published its own list in response. As of the day of this report (July 7, 2018), the US has implemented tariffs on US $34bn worth of Chinese goods and in response, as per certain newspapers, China would have added a second complaint to the one filed with the WTO in April4 , and announced its own tariffs against US goods. 

 

Stock Market Returns in the Last 5 years

7.  What are the direct consequences of all this?

US–China trade tensions may not subside soon and will likely dominate headlines and investor sentiment in the coming weeks. With each retaliation the impact size of proposed tariffs seems to be growing, followed by some quiet time. Chinese exports to the US make up 4.1% of China’s GDP, while US exports to China only make up 0.6% of US’ GDP. The USA is approximately a US $19Tr economy: If the cost to the US were to approach US $100bn (subjective estimate at this point), this would represent around half a percent of GDP. Yet, the impacts of these tariffs are likely to be heterogeneous affecting agriculture and regions like the Midwest and South/Southeast more so than others (e.g. soybeans).

8. What are the indirect consequences of all this?

The longer trade disputes continue, the more potential damage. As a master negotiator once said: “a threat has to be believed to be effective”. It is likely that we will not know how far this “tit for tat” goes on for, until it is over.

The real impact could be disruptions to supply chains (in view of the trade linkages talked about earlier), escalating tensions with other trading partners, damage to the export competitiveness from retaliatory measures, inflationary pressures on consumer prices, and delays in investment decisions and capital spending by companies taking a “wait and see” attitude. A spill-over effect of the US Dollar strengthening, via further interest rate increases to manage inflation would in turn feed negatively into US export competitiveness, affecting large capitalization companies more so than mid or small caps. The S&P 500 companies generate approximately 29% of their revenues from outside the US.5

As foreign savers effectively fund at least part of the US spending, retaliation at the capital account level is possible with reduced portfolio and direct investment in the US. 

9. What does it all mean for our portfolio management?

To see how we are dealing with the uncertainty of a possible trade war, please refer to our equity section.

BBVA Compass Global Wealth Investment Management Team

Head of Asset Management

Maria M. Holmes, AIF, CFP

Chief Investment Strategist

Dan Davidson, CFP

Directors of Portfolio Management

Mary Lynn Bronner, CFA
Graham Cauthorn, CFA

James Engelbrecht
Susan Green

Fixed Income Specialists

Eric Green
Thomas Joy

Richard Underwood, CFA

Portfolio Managers

Daniel Bush, CFA
Gary Chontos
Melissa Diaz

Marc Dobson
Brett Falkenhagen

Equity Trader

Valerie Ross

Analysts

Wilson Boren
Tyler Chapman
Sarah Dolan

Pascal Leduc
Natalie Manning
Allan Ngo

Investment Policy Committee

Mary Lynn Bronner, CFA
Graham Cauthorn, CFA
Gary Chontos
Dan Davidson, CFP
Marc Dobson
James Engelbrecht

Susan Green
Maria Holmes, AIF, CFP
Carol Rusciano
Anne-Joëlle Viguier-Galley, CFA
Marc Wenhammar

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Details you need to make a smart decision

1Policy Challenges from Closer International Trade and Financial Integrations: Dealing with Economic Shocks and Spillovers (OECD) - (Amador and Cabral, 2016; Baldwin, 2016)

2 United States. Office of the United States Trade Representative (USTR). Findings of the investigation into China’s Acts, policies and practices related to technology transfer, intellectual property, and innovation under Section 301 of the Trade Act of 1974, 22 March 2018. Section 301 gives the President the right to take action against trade policies that place an unfair burden on American commerce.

3Industry 4.0 is a name for the current trend of automation and data exchange in manufacturing technologies. It includes cyber-physical systems, the Internet of things, cloud computing and cognitive computing referred to as the fourth industrial revolution

 4China has requested consultations with the United States under the WTO’s Dispute Settlement Mechanism regarding the United States’ tariff measures on certain Chinese goods which would allegedly be implemented through Section 301-310 of the US Trade Act of 1974. The request was circulated to WTO members on 5 April. https://www.wto.org.

5US.SPINDICES.COM

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This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.

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Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), BofA Merrill Lynch U.S. Treasuries 1-10 years, BofA Merrill Lynch U.S. Agencies 1-10 years, BofA Merrill Lynch U.S. Corporates 1-10 years A-AAA, BofA Merrill Lynch U.S. Municipals 1-10 years A-AAA, Russell Top 200 Index, Russell 1000 Index, Russell Midcap Index, Russell 2500 Index, Russell 2000 Index, Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).