What a Trade War Means for Asian Bonds

Media reports have been focusing on a “trade war” following President Donald Trump’s decision to impose tariffs on up to US$60 billion in Chinese imports, targeting technology products. Beijing responded by imposing its own taxes on U.S. imports. The result has been an increase in market volatility on both sides of the Pacific. We believe news reports of protectionist measures are mostly noise and that investors should instead focus on long-term fundamentals.

Both good and bad trade war scenarios are possible. The good scenario is that tariffs are meant to get other countries to the negotiating table to encourage them to open their markets and initiate economic reforms. The United States-Korea Free Trade Agreement (KORUS FTA) is an example of U.S. actions to induce open markets. The bad scenario is one where countries are imposing tariffs for the sake of imposing tariffs, introducing more protectionism. Even in this scenario, the tariffs on US$60 billion of Chinese imports would affect only a small fraction of the Chinese economy.

We believe a good trade war is more likely than a bad one. Our analysis of the U.S. tariff list in response to Section 301 investigation (USTR301) reveals that the U.S. has carefully chosen strategically high value-added manufacturing sectors rather than a blanket tariff on the largest sectors. Largest trade categories such as toys, furniture, lamps, shoes and textile have all been spared despite their large percentage of U.S. imports from China. Instead, the USTR301 list has focused mostly on categories that China has stated in its “Made in China 2025” initiative such as semiconductors, machinery and various industrial goods. Similarly, the Chinese retaliation to USTR301 has been focused on maximizing the political impact to President Trump’s base by targeting specific interest groups such as U.S. farmers, car makers and airplane makers. Even almond farmers in the Republican districts of California’s Central Valley were taken into consideration. Combining all this technical information together, it is not difficult to see that both sides are playing a tit-for-tat game of trying to gain the maximum advantage in an eventual negotiation. While the eventual timing and outcome of such negotiation is still uncertain at this point, we believe it is likely that both sides are willing and able to negotiate for a political win-win.

Given this base case, we suggest that investors focus on the pillars underpinning our expectations of continued strong returns for Asian bonds. Historically, these pillars have been: stable U.S. growth; stable commodity prices; fairly valued currencies; fairly valued credit spreads; and low default rates. All of these factors are still in place. U.S. growth continues to be robust at 2% to 3%. Commodity prices have risen from multiyear lows and are relatively stable. Asian currencies have been appreciating since the end of 2016, but are not yet overvalued by nominal or real measures. Asia credit spreads also are near historical averages, unlike the overvalued credit spreads in the U.S. and Europe as a result of quantitative easing. Finally, default rates are hovering at historical lows of around 1.5%.