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The winners in a US-China trade war

| May 10, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Trade war between the US and China has drawn most of the market’s attention to the impact on the combatants, but the most interesting twist may come for countries playing spectator to the fight. Canada, Japan, Korea and other countries well integrated into global trade stand to quietly take on bigger roles as suppliers to the US, China and elsewhere. Foreign currency reserve balances may find their way back into the US Treasury market, and US credits sensitive to business in those countries may do better than expected.

Tariffs imposed between the US and China almost certainly will hurt both sides, but the complexity of international trade today creates some potential winners. Manufacturers in both countries will have to absorb higher upstream costs for any inputs from the other country, creating an opening for spectator countries to supply customers worldwide at a lower cost. Manufacturers in the US and China—including their suppliers—hurt by tariffs on their end goods stand to lose scale and productivity and become vulnerable to competition from spectator industries.  Industries in the US and China initially protected by tariffs and could see better domestic demand, but some will still have to compete with other global suppliers.

The IMF recently estimated that bi-lateral tariffs between the US and China would hurt both countries, with China taking the brunt (see Figure 4.12.2 here). But the same analysis found that Canada, Korea and Japan would come out as the biggest winners, with Germany, Italy, the UK and France also doing well.

Korea and Japan have long invested in US fixed income, so spillover from US-China tariffs could include better flows from portfolios in these spectator countries. And US companies doing significant business with countries that win in a bi-lateral fight also could do well. Of course, bi-lateral tariffs would hurt the broader outlook for the economy in the US and China.

The US Treasury market has rallied and credit has widened as trade friction between the US and China has heated up recently. That seems justified by the risk to US growth and a general flight to quality and liquidity.  Some investors worry that falling trade with China could limit the demand for US Treasury debt but may not have considered improving demand from spectator portfolios. Credit markets may have missed the potential for some names to do better.

The potential for some countries to benefit from US-China tariffs raises prospects that the two countries over time might impose tariffs more broadly to take away the spectators’ initial advantages. The IMF looked at that scenario, too, and losses to both the US and China fall. The biggest difference comes in the outcome for other countries. They all become losers, too.

* * *

The view in rates

Concerns about low inflation have started weighing on Treasury yields, and recent CPI data did nothing to relieve the pressure. Renewed discord over trade and higher tariffs on Chinese goods has pushed equities lower, credit wider and 10-year Treasury yields down another 5 bp to 10 bp. Eventually, growth should push 10-year rates a little higher, but unless a new trade agreement is brokered, expect the fair value level of 2.75% to remain out of reach.

 The view in spreads

Weakness in equities leaked into spread product, but markets appear to have stabilized at wider levels. Lingering indigestion from heavy corporate supply in both investment grade and high yield may take time to clear up. Over the longer term, a relatively flat yield curve, low volatility and heavy net supply of Treasury debt should steadily re-tighten spread markets. The longer the Fed remains patient, the longer the spread advantage in assets other than Treasury debt compound to the advantage of portfolio return. Leverage and loosening of underwriting remain a concern in investment grade corporate debt and leveraged loans, but concerns about recession, which would trigger those vulnerabilities, have diminished. Agency MBS could see a softening of bank demand, but it should still outperform credit.

The view in credit

Companies have started to divert cash flow toward paying down debt, have started to sell non-core assets and have curtailed stock buybacks. Management has heard the concerns of debt investors. Households continue to look strong with low unemployment, rising home prices, and generally good performance in investment portfolios.

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