Market declines: US LIBOR or US trade war?

It is very easy to point the finger at US trade sanctions against China as a reason for the recent declines in equity markets. The prospect of a near-term confrontation, in respect of access to markets and IP protection (a free competition zone perhaps rather than a free trade area), is clearly unhelpful for global equity sentiment. China’s transition from a catch-up nation to an economic competitor always had to be resolved at some stage. However the second dynamic at work during Q1 18 is a rapid rise in US LIBOR, over and above that of official US interest rates. This is tightening monetary conditions rather faster than policymakers may have intended.

The temptation to tar the new US trade policy for China with Trump’s brush should be resisted. The entry of China into the WTO allowed the nation to trade with the rest of the world, yet structural impediments to foreign competition and investment remained and in recent years sometimes reinforced. For example, to access Chinese markets, foreign companies must often have a local partner, such as a state owned enterprise. At first sight, many of the criticisms of China’s industrial policy with respect of foreign investment and intellectual property contained in the US Presidential Memorandum of 23 March appear well founded.

China has been able to continue to exploit its status in international eyes as a developing nation to maintain tight control of foreign investment and competition in its economy. By contrast, in the free trade area in the EU there has by necessity been strict rules on state subsidies and non-discriminatory access to member state markets. However, in China international observers have long complained of the many industries which are largely state owned and subsidised through the financial system, leading to overcapacity and the incentive to dump product on international markets.

In terms of intellectual property, Chinese corporates with often opaque ownership structures and financing sources have in recent years been roaming the globe buying Western assets in future growth industries. Intellectual property has also long been a concern of the US and in Europe, where further scrutiny of Chinese M&A has also recently been proposed.

In the US, the deal-blocking powers of CFIUS (Committee on Foreign Investment in the US) were strengthened as far back as 2007 following an abandoned approach by China National Oil Company for Unocal. The issues raised at the time – national security, intellectual property and the lack of a level playing field – are the same as those being raised now and are therefore not new. For the trade hawks, China’s strategy has been to play a long, slow and non-confrontational game while expertly taking advantage of all of the benefits of the openness of developed markets.

Trump’s broad brush has however tarred the process with the prospect of 25% tariffs on approximately 10% of China’s imports to the US, spooking markets. However, this is typical Trump – others with similar views on Chinese industrial policy such as Europe and Japan have lobbied hard to have issues addressed via the WTO in parallel. However, from the perspective of making a lot of noise for a domestic audience, and thus creating the political capital to come to the negotiating table from a position of strength, Trump’s move is not entirely irrational.

The WTO channel may yet be more productive in the long run, offering a carrot to the stick of populist US tariffs. For example, in the case of the recent US steel tariffs, the exemptions for Europe, Brazil, Korea and Canada which cover 80% of US imported steel indicate how much might be for show.

Separately from any potential “trade war”, in the recent market declines we still see the tell-tale signals of tighter monetary policy and easing economic momentum intersecting with relatively high equity market valuations. US 3m LIBOR rates have moved sharply higher during 2018 and significantly faster than expected risk-free rates, and currently stand 2.27%. The relative shortage of US dollars but absence of any move in cross-currency basis swaps or the USD exchange rate indicates this may be a domestic US phenomenon. There are a variety of explanations including the steady reduction of the US Fed’s balance sheet but importantly currently no sign of distress among US banks. The impact is therefore on floating rate funding costs, particularly in the corporate sector.

At Fed Chairman Powell’s press conference we were surprised this rise in market rates was not mentioned, as it does represent a significant extra tightening of financial conditions. The 25bps increase in the Fed funds rate was as expected and an extra rate increase for 2019 was indicated in the ‘dot plot’ projections. Powell was keen on a number of occasions to downplay the weight which should be attributed to the dot plots, further moving away from his predecessor’s forward guidance. On a number of occasions during the press conference he emphasised that the only decision that had been taken was to raise the policy rate by 25bps in March.

It is however the case in our view that markets cannot at present rely on a Fed put. Powell referred briefly to “some” equity prices and “some” commercial real estate being aggressively priced, which suggests that a fall in either of these markets would be unlikely to change the path of monetary policy. The modest increments in growth forecast by Fed policymakers are attributable to changes in fiscal policy and the Fed’s room for manoeuvre is in any case limited by the very low level of current US unemployment.

Therefore, with the benefits of US tax reform and the tailwind of economic momentum of 2017 in the rear view mirror, US and European equity investors are now contending with a slowing of economic momentum in Europe, high valuations and tightening monetary policy, in addition to significant headline risk in respect of a “trade war” over the next quarter. We believe equities are unlikely to make substantial upward progress in these circumstances and that investors should continue to position portfolios cautiously.