Monthly Insights. Ryan Lam, CFA. 18 July A Survival Guide to Trade War. Head of Research

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Ryan Lam, CFA Head of Research ryan.lam@shacomb

hk +852 2841 5283 Monthly Insights 18 July 2018 A Survival Guide to Trade War The quest to understand Trump s position is like trying to ascertain the position of a sub-atomic particle: it follows a

1 Ryan Lam, CFA Head of Research Monthly Insights 18 July 2018 A Survival Guide to Trade War The quest to understand Trump s position is like trying to ascertain the position of a sub-atomic particle: it follows a probabilistic distribution with no exact position. So where to look for insurance in the crossfire? Investors see the trade skirmishes as more a company-specific earnings risk than an across-the-board economic shock. A relative calmness in commodity market would put commodity exporters like India, Indonesia and Thailand in a firmer footing. Small- and mid-caps with vast domestic exposure should remain well insulated from further trade friction. The fairly-valued EU is on top of our mind. The right way to think of the endgame is not to solve the problem forward, but solve it backwards. What in the end, does China want to achieve? Not being bullied around. How can China get there? Frame a growth model that is less US-dependent. A predilection for EU and Japanese manufacturers over their US counterparts may emerge at the policy level, if trade war tensions escalate.

2 Theme Article No more World Cup to keep us distracted at last. Back to basic, it is bizarre to flip through a financial periodical without coming across an article covering the dire consequence of the onagain off-again trade war. This question must have been asked a thousand times What s Trump s motivation indeed? Exhibit 1: The Search Popularity for Trade War on Google /2016 7/2016 1/2017 7/2017 1/2018 7/2018 Source: Google, Shanghai Commercial Bank Some think that his threats are tactical move to bring a better deal on the table, other simply dismiss his gameplan as the product of a disordered mind. By any stretch, we can t claim ourselves as the go-to person in diplomacy or psychology. But we do know some common traits shared by human and particle. The quest to understand Trump s position, in our eyes, is like trying to ascertain the position of a subatomic particle: it follows a probabilistic distribution with no exact position. The dreadful prediction needs not detain us here. We shall spend at least part of our war chest to prepare for a slippery slope. The well-known Kelly criterion casts lights on how to allocate our capital under uncertainty you shall bet in accordance with your confidence level. This however gives rise to another vexing question: Where to look for insurance in the crossfire? We have a handful of ideas:

3 Switching out to Southeast Asia We would avoid positioning for an escalation through assets in Hong Kong, Taiwan, Singapore and South Korea. Why? These economies are cobwebbed with China s value chain. Weathering unequal burden, bond yields in North Asia and Southeast Asia are no longer bedfellows. Bond yields in Korea, Singapore and Hong Kong have already fallen at a pace unmatched by their peers (Exhibit 2). The relative calmness of commodity market in spite of the equity sell-off has been equally revealing. Apparently, investors see the trade skirmishes as more a company-specific earnings risk than an across-the-board economic shock. A stabilization in commodity prices would put commodity exporters like India, Indonesia and Thailand in a firmer footing. Exhibit 2: 1-month Change in 10yr Gov t Bond Yield Bps Exhibit 3: Euro Stoxx 50 & Euro Stoxx Mid 1 Jan 2018 = Euro Stoxx Mid Euro Stoxx 50 Source: Bloomberg, Shanghai Commercial Bank Source: Bloomberg, Shanghai Commercial Bank Riding on the domestic tide It is easy to tell exporters are bearing the brunt of rising import duties. Small- and mid-caps with vast domestic exposure should, in other words, remain well insulated from further trade friction. Going down the causal chain a step further, we all know valuation prevails as times of financial turmoil. The fairly-valued EU market is therefore on top of our mind. We generally like the idea of long small- and mid-caps in the Eurozone (Exhibit 3).

4 From past success to ferocious later-comers For anyone familiar with game theory, the right way to think of the endgame is not to solve the problem forward, but solve it backwards. What in the end, does China want to achieve? Not being bullied around. How can China gain a stronger hand to play? Frame a growth model that is less US-dependent. A predilection for EU and Japanese manufacturers over their US counterparts may emerge at the policy level, if trade war tensions escalate.

5 Country Notes US Humming along Sino-US trade tensions have ramped up once again. A pugnacious Trump has ordered to impose 10% import tariffs on additional Chinese goods worth USD200 billion. USD200 billion of imports represents about 1% of US GDP. Multiply 1% by a tariff of 10% gives us 0.1%. Allow for some substitution away from Chinese goods, and the number drops below 0.1%. That said, the real significance of the tariffs is not so much. The US economy will keep humming along. EU Germany and Central Europe will be hardest hit by auto tariffs Trump threatened a 20% tariff on imported cars originated from EU. With about 1.2 million vehicles shipped to US last year, the tariff could shave percentage point off growth in Eurozone GDP. An overwhelming focus on oversea market would leave Germany and Central Europe more exposed. UK Nowhere near the best of both worlds The May administration published its Brexit White Paper this month. To preserve the main features of the existing customs arrangements like zero tariffs with the EU, the UK proposes unilaterally to apply the tariffs for goods whose final destination is the EU. We suspect the EU will remain highly skeptical if not outright dismissive of this proposal. Not to be forgotten: European leaders stay aloof from UK calls for a bespoke deal on financial services. We are not getting farther away from a no deal outcome than we were. Japan A brief reprieve While global trade frictions capture investors eyeballs, luckily for Japanese investors much of local news provided a positive distraction. Investors take solace from evidences that the Japanese economy revived in the second quarter. However, the devastating floods in western japan will take toll on economic activities in the quarter ahead. Mainland China Tightening bites Mainland s GDP growth slowed to 6.7% in the second quarter, a tad lower from a 6.8% growth recorded in the preceding quarter. Beneath the surface, however, there are red flags raised all over the place. A comfortably above-target growth in the first half allows policymakers great leeway to tighten credit belt. Worse still, fixed asset investment shows little sign of life. With fierce headwinds brewing, more RRR cut is inevitable.

6 Foreign Exchange Outlook USD Stepping into the third quarter, the greenback has received a boost as broadening trade spat made US investors less willing to diversify into foreign assets. On the back of both positive carry and sound fundamental backdrop, a slow grind higher looks to be on the cards, barring the trade war threats evolves into a catastrophe. EUR Europe is a good bet to be next in line to face punitive tariffs. Uncertainty hanging over will dissuade investors from hoarding the EUR. Still, as summer lethargy has taken over, we feel there is no real trend and the range seems to be well in play. GBP GBP sell-off stands out following the resignations of key government ministers. At the margin, we doubt the Bank of England will surprise the market with dovishness. It puts another barrier in the way of stronger GBP. The market modus operandi should be to sell rallies from highs. RMB Renminbi is behaving as expected of a currency where the economic prospect is being questioned and monetary easing is around the corner. The PBoC is unlikely to use the currency card as a retaliation tool, but that does not mean that 6.7 is a deep line in the sand. Merely reversing its year-to-date advance, it is not yet at levels that would cause policymakers too much discomfort. The CNH could have another leg lower on any headline attack. JPY Even the safe haven currency can t stand in the way a relentless dollar bid. The technical break above 112 against the USD appears significant, as the BoJ s dovishness, summer carry trading, increasing outbound M&As by Japanese companies and potential spillover of the trade dispute all present further downside risks to yen. The pair faces little resistance up to 114. AUD It will likely prove difficult to place much weight on data over the next several weeks, particularly with the ever-present risk of trade headlines. The path of least resistance feels biased to the downside.

7 NZD The combination of below-target inflation and falling immigration is set to keep the RBNZ on hold. With the most dovish outfit in the G-10 space, Kiwi is unlikely to rally on back of its own merits.

8 Table 1: GDP Growth and Rates Forecasts GDP growth (% YoY) Key policy rate (% yearend) F 2019F F 2019F US Eurozone UK Japan China* Hong Kong^ *1-year lending rate, ^Prime rate Source: Bloomberg, Shanghai Commercial Bank Table 2: Foreign Exchange Outlook Yearend target Current 2018F 2019F EUR/USD GBP/USD USD/JPY USD/CNH AUD/USD NZD/USD Source: Bloomberg, Shanghai Commercial Bank Table 3: Implied Volatility (At-the-money) 1-month 3-month 1-year Value Monthly Monthly Monthly Value Value Change Change Change EUR/USD % % % GBP/USD % % % USD/JPY % % % USD/CNH % % % AUD/USD % % % NZD/USD % % % Source: Bloomberg, Shanghai Commercial Bank

9 Recent Publications Bank of Canada Is Holding the Line Jul 12, 2018 Sailing With Second-Order Thinking Jul 9, 2018 World Cup and Renminbi Jun 29, 2018 Getting Defaults Right Jun 26, 2018 ECB s Dovish Tilt Caught Market off Guard Jun 15, 2018 Fed at the Crossroads Jun 14, 2018 Riding the GBP Rollercoaster Jun 11, 2018 How to Play with Trump s Fickleness Jun 6, 2018 How Not to Think About Oil Rally May 28, 2018 Are We Pricing Xiaomi Right May 16, 2018 The Perfect Storm for Argentina May 8, 2018 Fed on Autopilot May 3, 2018 Crossing 3% Threshold Apr 26, 2018 The Three-Body Problem in the Peg Regime Apr 24, 2018 PBoC s Ambush Rattled the Market Apr 18, 2018 HKD in the Crosshairs Apr 13, 2018 How to Read Xi s Conciliatory Tone Apr 11, 2018 Deciphering the Tanking Yield Apr 6, 2018 The Intricate Linkage between Tariffs and Renminbi Mar 23, 2018 Quick Start to Powell s Fed Mar 22, 2018 Rising Tide of Protectionism Mar 20, 2018 Beyond 7.83 Mar 6, 2018 The ABCs of Italian Election Mar 1, 2018 A Deeper Look at the VIX Feb 22, 2018 Beyond the Stock Market Rout Feb 13, 2018 Are We Seeing Cracks Now? Feb 6, 2018 Yellen s Swansong Contains Few Surprise Feb 1, 2018 The January Barometer: Myth or Reality? Jan 26, 2018 Yield Spike Raises a Red Flag? Jan 19, 2018 New Year New Decision Jan 18, 2018 The Dollar Still Has Some Momentum Left Jan 10, 2018 Should We Worry About a Flatter Yield Curve? Dec 15, 2017 Yellen s Parting Move Dec 14, 2017 Is Bitcoin Just Another Bubble? Dec 5, 2017

10 Disclaimer - Investment Involves Risk Investment involves risks, investors may be subject to substantial losses. The exchange rates of any currencies or the price and income of any securities, funds, bonds or other financial instruments described herein may fall as well as rise. Past performance should not be taken as an indication of future performance. RMB is currently not freely convertible, the exchanges of RMB are subject to a daily limit imposed by Chinese and Hong Kong regulatory and supervisory authorities. RMB convertibility from offshore RMB (CNH) to onshore RMB (CNY) is a managed currency process subject to foreign exchange control policies of and restrictions imposed by the Chinese government. There can be no assurance that RMB will not be subject to devaluation at some point. Any projections and opinions expressed herein are expressed solely as general market commentary and do not constitute investment advice or guaranteed return. Shanghai Commercial Bank Limited and its affiliates may trade for their own account in, may have a position in, all or any of the currencies, securities or investments mentioned in this document. Customers are advised to make an independent review and reach their own decisions regarding the economic benefits and risks of any transaction and the legal, regulatory, credit, tax and financial aspects of such transaction relating to their particular circumstances. Neither the information nor any opinions contained herein constitutes a solicitation or offer by Shanghai Commercial Bank Limited to buy or sell, whether as principal or agent, any currencies exchange, securities, funds, futures, options or other financial instruments or provide any service or investment advice. Although the information herein contained is obtained or compiled from sources we believe to be reliable, Shanghai Commercial Bank Limited cannot and does not warrant the accuracy, validity, reliability, timeliness or completeness of any such information. Shanghai Commercial Bank Limited expressly disclaims any warranties of fitness for a particular purpose or duties of care and accepts no liability (whether in tort or contract or otherwise) for any loss or damages arising from any use of, or inaccuracies or omissions of the information. All information is provided as is, and is subject to change without prior notice. The information herein contained may not be reproduced, distributed or published in any medium for any purpose without prior express written consent from Shanghai Commercial Bank Limited. The information herein contained has not been reviewed by the Hong Kong Securities and Futures Commission.

Instant Thoughts. Ryan Lam, CFA. 18 April PBoC s Ambush Rattled the Market. Head of Research

Instant Thoughts. Ryan Lam, CFA. 18 April PBoC s Ambush Rattled the Market. Head of Research Ryan Lam, CFA Head of Research ryan.lam@shacombank.com.hk +852 2841 5283 Instant Thoughts 18 April 2018 PBoC s Ambush Rattled the Market The People s Bank of China announced a reduction of 1ppt in required