June 1, 2019

Market insights
Managing Director

Trade war impacts

The most discussed topic of the last 18 months is by far the trade war between the United States (US) and China. In this piece, we look at four impacts the trade war has and will have on the global economy.

  1. US inflation
  2. Supply chain adjustments
  3. Soft commodities
  4. Rare earth elements

1.  United States Inflation

With the United States & China having implemented additional tariffs on goods traded between the countries, we have seen evidence that the price of these goods have already increased or will increase in the future due to higher input costs. Generally, if we experience inflation in a growing economy, it is generated from demand or demand-pull inflation. This occurs when aggregate demand in an economy outweighs the aggregate supply, causing prices to go up. Essentially, demand pull inflation is the result of strong consumer demand. In the current environment we have cost-push inflation, which occurs when prices increase due to rises in the cost of wages and raw material. Higher costs of production can decrease the aggregate supply in the economy. As aggregate demand hasn’t changed, the price increases from production are passed onto consumers, creating cost-push inflation.

By analysing the commentary of United States Steel Corporation and Coca Cola (a large producer and user of steel and aluminium) we can see direct evidence that their input costs have increased. US steel stated in their most recent financial report that iron ore and coking coal imported from China has increased. Coca Cola, a buyer of aluminium products, also noted in their most recent report that the cost of purchasing aluminium cans & lids has increased due to tariffs. Thus far, we are yet to see these input costs be passed onto consumers (due to companies bearing the reduction in their margins in the short term). It is likely that as the profitability of these corporation’s decline over an extended period of time, they will be forced to pass these costs onto consumers to maintain their profitability, which will result in higher prices.

This increase in inflation, will add additional complexity to the United States Federal Reserve’s attempt to stimulate their slowing economy. The Federal Reserve have recently indicated they plan to cut interest rates. We anticipate that cutting rates to encourage spending in combination with a decrease in aggregate supply may cause an unanticipated upswing in US inflation.

2.  Supply Chain Adjustments

An interesting development of the trade war has been how other economies have benefited at the expense of the US and China. As tariffs are placed on Chinese goods, the US may import other goods from similar economies such as Vietnam or Taiwan. Although this substitution effect may be small in relation to the size of the US and China’s economies, the benefit from trade diversion can represent a material boost to the exports of these smaller economies.

The US has been imported approximately 12% less from China since the 2018 trade negotiations began. Vietnam’s exports have risen 38% in the first four months of 2019. This resulted in a 7.9% gain of its GDP. Similarly, Taiwan’s, South Korea’s and Bangladesh’s exports are up 22%, 17% and 13% respectively.

A report by Nomura titled ‘Exploring US and China trade diversion’ states that “US import substitution has benefited Vietnam, Taiwan and Korea in electronics products; Malaysia in semiconductors; and Korea and Mexico in motor vehicle parts. China’s import substitution, has led to beneficiaries in copper (Chile), soybeans (Argentina, Brazil, Chile and Canada); gold (Singapore, Hong Kong and South Africa); natural gas (Malaysia, Australia); and aircraft (France and Germany)”.

Many of the countries which have seen exports to the US rise are also likely to witness a fall in exports to China. This is because most of these countries are major suppliers of the intermediate components to Chinese factories. These factories will be exporting less to the US and thus, demand fewer intermediate components that are commonly sourced outside of China. Tariffs target not only the assembler of product, but also its suppliers.

There may be relative outperformance of companies that provide substitute goods to the US or China. Allocating capital to these economies and companies that are benefiting from rapid export growth as a by-product of global trade policy may provide a source of alpha.

3.  Soft Commodities

One group most affected by the increase in trade tariffs with China have been US farmers. This season has been incredibly difficult with two extremes, a drought for the most part of the season in combination with heavy rainfall during the recent planting season. These factors alone make this year’s soybean, soybean meal, soybean oil & corn crops challenging, however when you add the additional layer of increased tariffs, you can understand why we have heard that farmers are in uproar over the tariffs between China and the United States.

China has previously been the largest buyer of US soybeans due to their population growth and the expanding middle class. For previous seasons, US farmers have matched Chinese demand by choosing to plant soybeans over other soft commodities. After the tariff implementation date, demand from China has dropped significantly. The US exported $14bn & $12bn for 2016 & 2017 respectively, however in 2018 this figure dropped to $3.1bn. This lack of demand has dented Soybean prices which are currently trading at ~$938, this time last year they were trading at ~$1120. As prices drop, profitability of soybean farmers declines. This in combination with the rising price of steel used to manufacture their farm equipment makes 2018/19/20 very difficult years for farmers.

The deficit of Chinese demand for US soybeans will more than likely be filled by alternate countries (as mentioned in this article), with Brazil, Argentina, Chile and Canada the primary candidates. The quantity and consistency of purchases should provide a welcome uptick to the GDP of these economies, as we have seen in Vietnam.

4.  Rare Earth Elements

The China-US trade war took an interesting turn on the 20th of May this year as President Xi visited one of China’s major rare earths mining and processing facilities in Ganzhou. Since then, prices of rare earth elements (REE) have climbed almost vertically, with traders and investors speculating that China’s dominance in the supply of REE will be used as ammunition in the trade war.

China have two-fifths of the world’s supply of RRE, and account for 70% of global production. Its uses are vast, and certainly not limited to: cancer treating drugs, iPhones and F-35 fighter jets. Their importance is significant enough for the Pentagon to brief Congress in light of recent events due to their reliance on China’s processing and production. The US has a single rare-earth mine in California, and it exports about 50,000 tonnes of rare-earth extract each year to China for processing.

Recently, the editor of the state-controlled Global Times, Hu Xijin, tweeted: “Based on what I know, China is seriously considering restricting rare-earth exports to the US. China may also take other countermeasures in the future.” The immediate impact of this tweet gave catalyst to Lynas Corporation (LYC) rallying 15.48% in one day. LYC is one of the largest suppliers of rare earth metals outside of China. LYC signed an agreement this year with the Texas-based chemicals manufacturer Blue Line to build a processing plant in the US.

REE and producing company prices were in a significant downtrend over the last twelve months, however after this fundamental change, most have bucked the recent downtrend. These changes in trends may present opportunities to accumulate these companies at significantly discounted prices for the long term.

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