Jan Dehn, head of research at Ashmore, explores how the Donald Trump presidency will likely exacerbate the inevitable shift in global geopolitics and trade.
Trump will focus primarily on domestic policy, but that he will follow through with one of his campaign promises and withdraw from the TPP agreement – thereby eliminating any existing shackles on Chinese influence and trade.
Global markets have been busy pricing in something approaching perfection in the US outlook since Donald Trump’s election as president of the United States. The reality is likely to look rather different: fiscal stimulus and financial deregulation will create more inflation than growth and widen the trade deficit, while protectionism will lower the US trend growth rate. America’s withdrawal from the international stage will also change the global geopolitical balance.
Countries and industries the world over will be affected by these changes. Some will benefit, others will lose. However, the most important question from a global investment perspective is how the relationship between China and the US will evolve during Trump’s time in office.
We believe that two broad developments will emerge to dominate the relationship between the US and China over the next four years. The first is that China’s influence as a global economic and political power will increase as America shrinks from the international stage. The second development will be the Renminbi’s growing challenge to the Dollar’s current status as the pre-eminent global reserve currency as inflation returns to the US.
Trump will focus primarily on domestic policy
Markets have made a meal of Trump’s campaign references to trade wars, 45% blanket tariffs on Chinese imports and the dissolution of trade agreements ranging from NAFTA to TPP. We think these risks are significantly overstated. In fact, we expect Trump to focus mainly on the domestic policy agenda in his first term, not least because it would undermine his chances of re-election in 2020 if he were to commit the cardinal error of focusing too much on trade and foreign policy in his first term.
Donald Trump’s successful election campaign rested on a promise to fix a distinctly domestic problem, namely the declining quality of life of America’s beleaguered working classes. To deliver on his promise his remedies must also primarily be domestic in nature. The American way is to raise growth rates, to create jobs, to lift all boats on a rising economic tide. Attacking foreigners will simply not achieve this, because foreigners are ultimately not to blame for America’s recent stagnation and rising inequality. We therefore expect Trump’s policies to have a clear domestic focus in his first term, where the new president will be kept extremely busy dealing with Congress on matters ranging from corporate tax legislation, infrastructure spending and budgets to repealing or materially altering Obamacare, America’s climate commitments and financial sector regulation.
This is why investors should not expect fireworks on the foreign policy front in Trump’s first term. We certainly do not expect a trade war and the odds of a blanket 45% tariff on Chinese imports are poor, in our view, particularly since the US yield curve already faces bear steepening pressures, which could worsen significantly if China were to retaliate by selling its large stock of US Treasury bonds.
Withdrawal from the Trans-Pacific Partnership (TPP)
Indeed, the early announcement that the US intends to withdraw from the Trans-Pacific Partnership (TPP) may turn out to be the major trade policy initiative of Trump’s first term. Remember that TPP was a US-led initiative specifically designed to limit the growing political and economic influence of China in Asia and
Latin America. Yet, now it is the US itself, which is pulling out as clear a signal as one can get that America wants to play a much smaller role on the international political stage.
The collapse of TPP has left an enormous vacuum in terms of economic leadership in the Pacific Rim, which China is certain to fill. Indeed, China has already made great strides in forging closer ties with several Asian and Latin American countries, including the Philippines, Malaysia and Chile. More will follow. For example, the demise of President Park Geun Hye in South Korea may well see power shift to the Minjoo Party, which favours a much more balanced relationship between China and the US.
But TPP is a mere detail in the broader picture of rising Chinese global dominance. A realisation is growing among Asian and Latin American countries that their interests may be far better served by getting closer to China. It is simply a matter of cold economics – Chinese consumption will grow even faster than the GDP and China will eventually become a current account deficit country. In other words, China is just starting what will eventually be the largest consumption boom the world has ever seen at a time when heavily indebted US consumers face greater debt service costs in a rising interest rate environment.
Seen in this light, it is entirely rational for Asian and Latin American exporters to shift their focus from America to China. A stagnating, deleveraging and increasingly protectionist America is simply no match for a reforming, consumer oriented and increasingly open China when it comes to serving the national interests of exporters all along the Pacific Rim and elsewhere. And needless to say, deeper economic and trade ties beget deeper political ties too.
The rise of RMB
If, as we expect, Trump will pull America back from the international stage and oversee a rise in inflation then the world is going to need the RMB for two basic reasons.
First, the emergence of China as the dominant global economic power will inevitably require that the RMB replace the Dollar as the pre-dominant reference currency in global FX markets, because currency markets always benchmark against the largest and most liquid currency. The RMB will do exactly what the Dollar did to the Great British Pound in the inter-war years. For the same reason, it follows that Chinese Government bonds will also replace US Treasuries as the main benchmark for bonds. That is not to say that US markets would no longer matter. Of course the US will remain an extremely important market for both FX and bonds, but US markets will now exist within a multipolar world, where they are no longer the largest – China’s are.
Secondly, markets will need the RMB in order to safeguard the purchasing power of the world’s savings. Unable to repay their debts amidst a secular decline in productivity, rooted in debt itself, the US and other Western economies will ultimately have to inflate and devalue their way out from under their debt overhangs. China has anticipated this; it the reason why China pushed so hard to have the RMB approved within the SDR basket.
Today, the RMB is the only currency in the SDR basket which is not a QE currency and Chinese government bonds are the only bonds among the SDR members with positive real and nominal yields. As inflation becomes more evident in the US and later in the other QE economies the risk of significant – possibly explosive – RMB appreciation will steadily increase. The key trigger event is likely the sudden realisation among central bankers that US inflation will undermine the purchasing power of their FX reserves, which just happen to be overwhelmingly invested in the Dollar and the other QE SDR currencies. US inflation will of course also require major portfolio allocations among other institutional investors most of whom are not only limit-long Dollars, but also hardly exposed to China at all, given that China’s main domestic markets are not yet represented in the main benchmark indices.
The warning signs of US inflation have been with us for some time
The approach of almost full employment, full household deleveraging and the end of negative housing equity over several years evidence this. US core CPI inflation is already above the Fed’s 2% target. If Trump now follows through with his promises of tax cuts, fiscal spending and easier credit conditions for banks inflation will rise further. Productivity on the other hand looks set to continue to stagnate under Trump, because, as all trained economists know, trade protection and higher fiscal deficits reduce rather than enhance trend growth rates.
Of course, much depends on the Fed. However, the Fed is likely to struggle to get ahead of inflation. Never before has the Fed allowed the US economy to approach full employment with only two hikes on its books (this is assuming it hikes on 14 December). The Fed would need to hike some eight times just to get to neutral, a feat that very few analysts believe possible without triggering a severe recession. It therefore seems more likely that the Fed will raise rates more or less in line with inflation. This will keep real rates well into negative territory for the foreseeable future and won’t prevent inflation from rising. The Dollar should therefore sink rather than rise as real rates decline.
Viewed from a great height America is a nation in decline embarking on a path of populism, while China is a nation in the ascendency addicted to reforming its economy. Investors should therefore look beyond the market’s myopic kneejerk reaction to Donald Trump’s ascent to the US presidency. Investors should begin to allocate steadily and meaningfully out of the QE currencies and into RMB and a broader basket of lesser liquid EM currencies. It is safer and it pays better.