The US-China Trade War and its Implications.

The US-China Trade War and its Implications. Background and Overview The largest Trade War in history is currently underway as the two largest economies on the planet are fighting each other through imposition of tariffs and other trade barriers. Over the last 20 years the US trade deficit and the US trade deficit with China has increased at a CAGR of 18% and 22% respectively. China is the single largest exporter to the US contributing 22% to the US import bill in 2017 with a value of USD 552Bn. The US trade deficit with China (USD 375Bn in 2017) is more than half of its total trade deficit (USD 505Bn in 2017 1 ). President Donald J Trump has advocated protectionist policies long before he intended to run for the oval office. In 2011 he stated that China is neither an ally or a friend they want to beat us an own our country. The Trade War officially sparked in February 2018 with the US implementing Global Safeguard Tariffs, placing a 30% tariff on all solar panel imports and 20% tariffs on washing machine imports. In March 2018 the trade war exacerbated with the US imposing 25% and 10% tariffs on steel and aluminum imports respectively 2. The second phase of the trade war started when the United Stated Trade Representative (USTR) imposed 25% tariffs on over 1300 2 products (revised to 818 products in June) worth c. USD 50Bn. This time China retaliated with 25% tariffs on US exports to China worth c. USD 50Bn. The counterpunch by China, led to trade negotiations to bring the US trade deficit with China to USD 200Bn 2. The negotiations were however futile. The third round of tariffs were imposed in July by the USTR where over 6000 commodity imports from China worth c. USD 200Bn were subjected to a 10% duty. In response, China imposed a range of duties for US exports worth c. USD 60Bn and followed with a complaint on the WTO against the US. Thus, up to date, the US has imposed duties to Chinese exports worth USD 250Bn while China has reacted with duties on US exports worth USD 60Bn. US duties are mainly imposed to steel, washing machines, solar panels etc. whereas Chinese duties are imposed to agricultural products, textiles, chemical and medical equipment 2. At the G20 summit (December 2018), the two leaders agreed to a temporary ceasefire with China agreeing to purchase a substantial amount (quantity not confirmed) of agricultural, energy and industrial products from the US. In return the U.S has agreed to retain tariffs on USD 200Bn Chinese goods at 10% at the beginning of 2019 (earlier scheduled to increase to 25% 2 ). However, a time period of 90 days has been agreed by both parties for the aforementioned transaction to take place 3. The outcome of the transaction will largely define the intensity and the lifespan of the Trade War. 1

USD Mn USD Mn 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 US Trade Deficit & Trade Deficit with China Exports to the US by country (2017) 0 0 6% 5% Other -100,000-200,000-300,000-400,000-50,000-100,000-150,000-200,000 13% 41% China Mexico -500,000-600,000-250,000-300,000 13% Canada -700,000-350,000 Japan -800,000 US Trade Deficit (Left Axis) -400,000 US Trade Deficit with China (Right Axis) 22% Germany Source- US Census Bureau Source- US Census Bureau The outlook of the Trade War cannot be analyzed in isolation, and (Left largely Axis) depends on the US political landscape. President Trump is eligible to run for re-election in 2020 although it is likely that he will face a strong primary challenge within the Republican party from Senator Jeff Flake. However, an incumbent president is yet to be outdone in a primary election. Even if President Trump wins the primary election, potential Democratic candidates such as Elizabeth Warren, Bernie Sanders and Joe Kennedy will pose a tight challenge at presidentials. If President Trump gets re-elected in 2020 we expect the trade war to continue where as if the Democrats manages to win, it is highly likely that the trade war will be ceased. Republicans won all three houses in 2016 (The White House, The House of Representatives and the Senate). In 2018 they only managed to retain the Senate as the House of Representatives was won by the Democrats, hinting on a shift in voter confidence. We believe that this shift in power alone cannot predict the 2020 outcome and that it is too early make any prophecy. However, we foresee the Trade War to continue till 2020 4. Impacts on economies of US and China We believe that the Trade War will impact China more than the US given the high US contribution in Chinese exports (19%) compared to the contribution of China in US exports (8%). The US economy has performed beyond expectations in 2018 where the GDP growth stands at 4.2% for 2018 Q2 (QoQ) which is the highest since 2014, whereas its unemployment rate (3.9%) is the lowest since 1969. Further its consumer confidence is at a highest since 2009 while the Purchasing Managers Index (PMI) reached its highest level in 10 years in August 2018 (61.3) and has been over 57 for all 10 months completed in 2018. We foresee the US to end 2018 strongly and carry the momentum to 2019 as well 5. The main reason for improved performance could be comprehended as the corporate tax cut (from 35% to 21%). Trump administration also reduced individual taxation for the upper most income bracket (USD 600,000 per annum and above) from 39.6% to 37% 6. Therefore, the impeding effects on the US consumer through the trade war are likely to be compensated by job creation via corporate tax cuts. 2

GDP Growth % Unemployment % 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 US GDP Growth and Unemployment under Trump Administration 4.2 3.5 3 2.8 2.3 2.2 1.8 2017 Q1 2017 Q2 2017 Q3 2017 Q4 2018 Q1 2018 Q2 2018 Q3 GDP Growth %(QoQ) Unemployment % Avg. Unemployment (5yrs) 5.5 5.3 5.1 4.9 4.7 4.5 4.3 4.1 3.9 3.7 Source- Bloomberg The Chinese economy grew at an average rate of 6.5% in 2018 which is its lowest since the global financial crisis in 2009. This also portrays the vulnerability of the Chinese economy to subdued US demand. The GDP growth rate has failed to hit 7% in any quarter since 2015 which also due to the lackluster performance in the investments. Chinese manufacturing sector proved to be less than impressive as the PMI averaged 51 for the first 10 months in 2018 5. Nonetheless, the entirety of the slowdown in growth is not attributable to the Trade War. Since the recession in 2009 Chinese lenders have provided extensive loans for investments which ballooned the Debt to GDP ratio (265% in 2017) 5. However, these investments have failed to provide the desired results in terms of return. We expect the investments to continue at a mundane growth rate in 2019 as well. It should also be noted that the Chinese dependency on exports has reduced over the years (19% exports to GDP in 2017 as opposed to 35% in 2007 5. Therefore, we do not expect the GDP growth rate to fall below 6% given the considerable growth in its middle-class (29Mn in 1999 to 421Mn in 2013 7) which might offset the trade war implications partially through consumption growth. Global leaders are neutralizing their foreign relationship stance in the midst of the Trade War. Japanese Prime Minister Shenzo Abe met his Chinese counterpart in October which was interpreted by many political analysts as an act of navigating between the two with Trump s threat on Japanese exports to the West in the backdrop. Going forward, more nations who have close ties with the US might take a neutral stance 3. Equity and commodity markets and global industries. US equities have performed marginally well during 2018 (S&P 500 YTD up by 1%) with corporate tax cuts and consumer confidence boosting company results. Shanghai Composite Index have plummeted by 20% (YTD) amidst the trade war. However, trade war is only partially responsible for the Chinese market downtrend as MSCI Emerging Markets Index and the MSCI Frontier Markets Index have also dropped heavily during the year (12% and 15% respectively) 5. FED (US Federal Reserve System) rate hikes have caused the USD to appreciate against major global currencies and the subsequent impacts have been negative in emerging and frontier equity markets. It is needless to say that oil prices are impacted when the two largest oil consumers on the planet are in a Trade War. US and China contribute 20% and 13% to world oil consumption respectively. US is also one of the largest oil producers in the world. Any speculation on subdued demand from either of the countries will dampen prices. In 2018 the prices however rose during the first 10 months and reduced substantially since mid-october (YTD decline 13% 5 ). 3

USD per 1 Metric Ton USD per 1 Metric Ton Firstly, the OPEC s decision to curtail production earlier this year had a significant impact on prices which was exacerbated towards the middle of the year with US trade sanctions on Iran which reduced the world oil supply. In addition, Venezuelan oil output plummeted heavily due the ongoing political turmoil. However, the rising Russian outputs and strong US reserves controlled the intensity of price upswings. In 2019 global oil demand is expected to surpass 100 Million Barrels Per Day (Mbpd) level for the first time in history while the supply side remains stable with US and Russian outputs. Price is expected to settle in the 55-60 range (currently $52.44 per barrel - Generic 1st Crude Oil). In our view, prevalence of a trade war will cause the prices to plunge in the medium term once the supply side factors settle down. Global metal prices saw a sharp decline in 2018 triggered by Trade War and related speculation activities. Copper and aluminium prices declined by 16% and 13% YTD respectively 5. China is the largest copper importer in the world and therefore copper prices are much vulnerable to a Chinese demand shock. Chinese investment slowdown and Trade War impacts will further dampen copper prices as per our view. China is the second largest aluminium supplier to the US (43% contribution to total US aluminium imports 1 ) and since the US demand for Chinese aluminium is reduced, aluminium prices elsewhere will drop in the near term as there is excess supply from China. Metal Prices YTD Movement 7300 7100 6900 6700 6500 6300 6100 5900 5700 02/01/2018 02/04/2018 02/07/2018 02/10/2018 2800 2600 2400 2200 2000 1800 Copper Aluminium Source: Bloomberg China is the largest apparel exporter in the world with a market share of 34%. US is the largest apparel importer in the world (USD 28Bn in 2017 8 ). However, the second and third largest apparel exporters (Bangladesh and Vietnam) have only 6% of market share each, depicting the inability to expand production to face higher US demand. This will surge prices. Regional Impacts South Asia is expected to be the fastest growing region in the world and is largely dependent on the regional giant India. With strong private spending growth, India is expected hold the regional growth together in 2019. Exports will have a positive impact through the US demand shift (US is the largest trading partner of India) while currency depreciation in the region has made regional products even more appealing to the US consumer. 4

Spill-over effects to SL Oil is single largest item in the SL imports basket (17% 9 ) and has proved to have significant impacts on macro variables such as inflation in the country. Although the trade war impacts could reduce oil prices, the import bill will not be affected much due to substantial currency depreciation. US is the largest export partner (26%) of Sri Lanka while China is the import partner (22%) 9. Apparel exports dominates the exports basked with a 44% contribution and we believe that the sector will gain from the trade war with US shift in demand from China to other countries. Currency depreciation (12% YTD 5 ) will also auger well. Thus, higher exports growth is to be expected in 2019 which will translate in to a higher GDP growth. Construction sector in the country is expected to gain from the trade war with lower metal prices. However, whether the negative effects from the corporate tax hike from 15% to 28% could be reversed is questionable. We believe that the overall impacts of the trade war to the SL will be positive with expected higher exports growth in the near to medium term. Capital market in SL is not directly correlated with US, Chinese and Emerging capital markets. 3 year correlations with the S&P, Shanghai Comp and MSCI Emerging Market indices stands below 0.25 5. Thus, we do not foresee the SL capital market to be affected notably by global and regional capital market developments but there could be an indirect impact from commodity markets through the BOP (Balance of Payments). Sources: 1 - US Census Bureau 2 - US Trade Representative s Office 3 - CNBC 4 - The Guardian 5 Bloomberg 6 US Department of Commerce 7 China Power 8 www.statista.com 9 Central Bank of Sri Lanka (CBSL) By Gayan Rajakaruna & Sahan Rathnayake Research Analysts, LOLC Securities Limited. Research Contacts T.P -+94 11 588 9837 Email - research@lolcsecurities.com General Disclaimer LOLC Securities Limited is a company incorporated in Sri Lanka and licensed by the Securities and Exchange Commission of Sri Lanka to operate as a stockbroker/stock dealer in Sri Lanka. LOLC Securities Limited is a trading member of Colombo Stock Exchange. This research is based on information from sources that LOLC Securities Limited believes to be reliable. Whilst reasonable care has been taken to ensure accuracy of the information presented in the research, LOLC Securities Limited does not give a guarantee on the accuracy of the information presented in the paper nor will take the responsibility on investment decisions taken based on the information provided by the research and hence LOLC Securities Limited nor its employees accepts any liability whatsoever for any loss arising from investments decisions taken using the information provided in this paper. The reader also should note this paper does not give recommendations to any particular category of investors and investor should consult investment advisors for further clarifications regarding risks involved in investing in equity market. Investing in securities has inherent risks with no guaranteed return and price may be subjected to significant volatilities. No part of this report should be considered as a solicitation to buy or sell any security or product or to engage in or refrain from engaging in any transaction. LOLC Securities Limited or its employees may or may not hold positions in the securities discussed in the research and the information provided in the research should not be construed as a buy or sell instruction for any securities mentioned in the research, Unless otherwise specifically mentioned. This research must not be copied in whole or in part or distributed to any third party for commercial use without permission from LOLC Securities Limited. LOLC Securities Limited s other staff including sales people, traders and other professionals may provide oral or written market commentaries or trading strategies to our clients which reflect opinions which are contrary to the opinions expressed in this research which may be influenced by different circumstances. 5