Let’s be honest. This “trade war” between China and America is not really a surprise. While the media is having a ball hyping the story, the truth is that this “war” - so far, it’s still more of a scrimmage - is but a continuation of the US-China “currency war” that has been going on for some time now. Nevertheless, that should not lead us to disregard it as irrelevant.

Admittedly, financial markets have been largely complacent about the whole affair. Generally, markets are right. But, quite often they’re not.

Big Picture in Brief

It’s always dangerous to summarize a very complex matter such as the global economy in a few short paragraphs. By nature, summaries miss a lot of “important stuff”. On the other hand, simple is beautiful. Keeping things in perspective and achieving a simplified but largely accurate view of a problem can be very helpful. So, I’ll give it a go.

We live in a financial world that, for the past 10 years (and, truthfully, longer than that), has benefitted from the artificial inflation of the monetary base, all around the globe. Central banks have flooded the world with “cheap money”. This has led to gigantic misallocations, distorted interest rates and market prices. Investors have benefitted as financial assets have been inflated. Instead of the “invisible hand of free markets”, it’s the heavy hands and thick, twitchy eyebrows of central bankers that have been steering the global economy.

Every credit cycle leads to excesses, which then need to be corrected periodically. However, this credit cycle and the rise of prices in financial markets in the West, have been extended for an unusually long time. Have central bankers found the recipe to keep this going in perpetuity? Of course not. On the contrary, they are in an uncharted and highly uncertain territory. Don’t expect them to be “in control”!

While the last credit cycle ended primarily on the back of overvalued real estate prices and the system’s abuse in the lending sector (i.e. CDOs, MBS, etc.), the excesses of this credit cycle appear to be unfolding in the economies and companies of emerging markets, from Turkey and South Africa, to China. Emerging economies have built an impressive mountain of debt during this cycle, growing their foreign liabilities from USD 5 trillion to USD 19 trillion(!). They are now finding out, once again, that there is no such thing as a free lunch… ever!

Their problems have only just begun. Their weak balance of payments and excessive debt is coming back to haunt them. Huge capital outflows are depreciating their currencies, growing their inflationary rates and, bit by bit, destroying their economies.

While all other central banks, including the European and Japanese central banks, seem set on continuing their low interest policies, the US is on a path of tapering, incrementally normalizing their monetary policy. This process is leading to a considerable removal of USD capital, a reduction of capital that is, first and foremost, hurting the weakest economies, or those economies with a weak balance of payments and large foreign debt.

Argentina, Iran, Turkey… China!

Turkey was the latest - but certainly not the last - domino to fall. Erdogan bet on growing his economy with foreign debt. He’s now run into the problem of US trade sanctions and tariffs. With much of his debt denominated in US dollars, and with the Turkish lira in decay, that debt is rapidly becoming difficult, if not impossible, to finance. But why does Turkey matter? Well, for one thing, roughly USD 400 billion of Turkish debt is financed by European banks, some of which are in trouble already.

The growing crisis of emerging economies is starting to rear its ugly head elsewhere as well. We need to keep a close eye on yield spreads and such indicators as the CDS spreads (credit default swap spreads). As the economies of emerging markets slow down, the impact will be felt in Europe and in the US too, even more so when one of those economies is China.

This development is not new. It’s a classic example of increasing scarcity of dollars, sucking liquidity out of weaker economies, driving the price of the dollar up, and destructively eating its way toward the larger economies. This process will continue until something else gives: either until the Fed changes tack and starts inflating once again, which is not in the cards for now, or until the rest of the world starts normalizing too, as inflation increases on a pace that is faster and stronger than desired.

I expect the latter to materialize over the next 12 months. That, of course, will start affecting financial markets in Europe and the US. And, whether it be a “hissing” or a “popping” process, the correction in stock AND bond markets can be expected to be severe.

So, what about the trade war?

Markets have been relatively tranquil about all this. Most commentators are pointing at the trade resolutions America has reached with Europe and in the context of NAFTA. In both cases, measured and balanced agreements appear to have been ironed out. However, the question is whether this will also be the case with China.

Surely, the Chinese can be expected to aim at “saving face”. Possibly, they may have some diplomatic avenues to achieve this. However, President Xi Jinping, who has pretty much been given a “mandate for life” only a few months ago, will do everything possible in order to not look weak. He won’t start his one-man reign by backing down in the face of Donald Trump’s fiery rhetoric and very public threats. So, what options remain? How can he fight this “trade war” with something other than tariffs?

China imports far less (roughly USD 150 billion per annum) than it exports to the US (roughly USD 500 billion). Clearly, China can only retaliate with tariffs to a very limited degree. They would literally run out of goods to impose tariffs on faster than America.

Another option - one widely popular and generally considered a “nuclear weapon” - is that the Chinese could start selling their large holdings of US treasury paper (roughly USD 1.2 trillion). The assumption is that this would drive up US interest rates and therefore lead to rising mortgage rates, damaging the U.S. housing market and forcing the US into another real estate crisis and economic recession. Trump certainly doesn’t want that.

However, this option is flawed too. As soon as they start selling, rising interest rates will devour the value of their reserves, weakening their balance sheet. Moreover, plenty of market participants may be keen to buy. And, if the market does not buy those treasury securities, the US may decide to do so themselves, thereby neutralizing the effect of the Chinese maneuver from the beginning. The US Treasury controls the digital ledger that records ownership of all Treasury securities. They could literally freeze the Chinese accounts, instantly stopping them in their tracks. So, this option might not only prove largely ineffective, but it could also backfire on China.

However, the Chinese are not entirely without a trump card (forgive the pun) up their sleeves. They do have another “nuclear” option, one they have tried and tested in the past: currency depreciation. It is a tactic that Americans have criticized China on for decades already. And, as Chinese exports decline, partly due to weakening emerging economies around them, and partly due to Trump’s tariffs, they may decide to prioritize exports over the stability and globalization of the Chinese currency.

USD/RMB (Offshore Renminbi), YTD 2018

Source: Yahoo Finance (finance.yahoo.com)

In other words, Xi Jinping may well convert this “trade war” into the more traditional “currency war”. In fact, I believe that will be the natural and most effective reflex, unless an agreement is reached between the two superpowers.

As Trump imposes his tariffs on Chinese products, the Chinese may devalue their currency at the same rate, thus neutralizing the effect of the tariffs; the tariffs will increase the price of the goods, while the currency devaluation will bring it back down. The net effect is zero and the tariffs won’t achieve what President Trump is trying to achieve.

In fact, China employed this option not too long ago. When they devalued in August and December of 2015, stock markets crashed on both occasions. That too is not what Donald Trump wants.

In conclusion, we may be looking at a classic “game of chicken”. Who will blink first? I don’t think it will be China and that gives me plenty of reasons for concern. We can only hope that this round of Trump-style “negotiation” comes to a measured and constructive end. If not, you can expect financial markets to tank and the US may be pushed into its next recession, together with a few others…