The volatility in global markets that began in February continued through March. Equity markets around the world fell along with bond yields as the shift down the risk curve continued. For the month, the MSCI All Country World Ex-US index was down 1.71% and finished the first quarter down just over 1%. Headline news from the US government once again affected global markets as trade tensions were escalated throughout the month.
Politics also dominated European news in March as Germany and Italy were both left without unified governments after recent elections. Angela Merkel has so far failed to unite her Christian Democratic Party with the Social Democratic Party to form a coalition in Germany. As a result, the German equity index underperformed the greater European benchmarks in March and is now the worst performer in the Euro area in 2018. Meanwhile, Italy’s general election produced surprising results with the Five-Star Movement achieving a much greater share of the votes than expected. They will now likely have to forge ties with Lega, which is another inexperienced party on the national scene but also one capturing an increasing piece of the anti-establishment vote. The Italian equity market has been steady all year and is now the best performing market in Europe.
Brexit negotiations continued despite the lack of leadership in Europe’s biggest economy. The UK managed to negotiate a deal to continue to trade freely with the EU markets until the end of 2020 while trying to secure individual trade deals with each country. Northern Ireland remains a sticking point in the negotiations due to unanswered questions regarding the border. Meanwhile the political atmosphere around Theresa May, and her party, has regained a sense of stability, if only for the moment.
In China, the communist party officially voted to scrap the two-year presidential term limit giving Xi Jinping unfettered power indefinitely. This reversal of some of the advancements toward a more democratic approach in China is disappointing, in our opinion. Meanwhile, the state-owned Agricultural Bank of China, one of China’s top 4 banks, was quietly recapitalized in March through a $15 billion private placement bought by other state-owned enterprises. This will likely be followed by capital raises by other banks as the new accounting rule, IFRS 9, will expedite the recognition of bad loans – long an issue in the Chinese banking system where bad loans seem to avoid being labeled as non-performing.
Thoughts On The “Trade War”
The Trump Administration announced across the board tariffs on steel (25%) and aluminum (10%) coming from several countries and set off a string of meaningful events. We believe the timing of these tariffs are indicative of their overarching purpose. It is useful to take a step back and look at what has happened in the steel market over the last several years to really appreciate the significance of these recent actions.
The Chinese steel market is entirely state-owned and has been used as an economic tool for many years. The massive output from this industry acts as a lever the government pulls in order to help achieve overall economic growth targets for the country. In the process, however, it has devastated the global steel market with huge increases in supply. From 2009 to 2015, crude steel exports from China grew over 350% from 2 million tons per month to over 9 million tons per month.
To put some perspective on this amount, ArcelorMittal, by far the largest steel producer in the world, produced a total of 7.75 million tons per month in 2017. The chart above shows the relationship of this growth in Chinese steel exports and the price of one of the biggest finished steel products, hot rolled coil (HRC). As the chart above shows, the price of steel held steady through the first half of this period but then started to collapse in 2014, as exports really intensified.
Under normal conditions, the market would have had to adjust to such an increase from a supplier. However, the problem in this situation is that China was illegally subsidizing the steel companies with lower input costs and then dumping the steel into global markets. In 2015, steel prices were below the cost of production for most steel producers around the world and this forced governments to take a tougher approach with the World Trade Organization (WTO). The US Department of Commerce took a stand and officially issued duties on certain Chinese steel products in early 2016; Europe and Brazil followed closely behind and the effects were meaningful. Chinese exports dropped significantly by the end of 2016 and have been decreasing ever since. Steel prices, have since more than doubled from their lows.
So why is President Trump placing new tariffs on steel now? We now know these tariffs are not really about steel; on March 13th, President Trump admitted the policy was more of a negotiating tactic. This one sweeping tariff will impact many countries and force them into new trade negotiations. Several countries have held talks with the US and on March 22nd, U.S. Trade Representative Robert Lighthizer told the Senate Finance Committee that the U.S. will “pause the imposition” of steel and aluminum tariffs for Europe, Australia, South Korea, Argentina and Brazil. Canada and Mexico have also already held talks with U.S. trade representatives setting up a total renegotiation of NAFTA.
The biggest target for the US president, however, is China and its overreaching trade policies. The first year a trade deficit with China really appeared was 1986 and has since grown just over 19% per year to $375 billion in 2017. Though large, this imbalance by itself is not hampering growth in the US. Much of that imbalance is recycled into US Treasuries which help to finance our budget deficits. The real iniquity, however, is the means by which this deficit has been able to grow.
The Chinese government tends to think very long term and, in doing so, they regularly produce grand blueprints for how economic targets are to be achieved. In 2006, the “Medium- and Long-Term Plan on the Development of Science & Technology” was developed to outline how the country could become a leader in these fields over the following 15 years. The core of that plan focused on developing leading-edge advanced technologies through investment in R&D from state and industry sources, accumulation of intellectual property, setting of distinct technical standards, and leveraging access to the Chinese market in exchange for foreign technologies. This was followed in 2013 by the “Made In China 2025” playbook which adhered to much of the same methodology as the 2006 document. These plans, and the policies that have been implemented because of them, have not only suppressed foreign competition but have created a protected Chinese market.
Today, it is virtually impossible for foreign companies to freely sell into the Chinese market without working with a Chinese partner or otherwise sharing their intellectual property. While not direct tariffs, the government has put up barriers to entry that directly harm foreign companies. As a result, subsidized Chinese companies operating from a closed domestic market and selling into an open international market has enabled the Chinese economy to benefit disproportionately.
In 2015, the Office of the Director of National Intelligence estimated that economic espionage, through hacking, costs US companies over $400 billion per year. In 2017, the Commission on the Theft of American Intellectual Property followed up on that report with an even higher estimate of $600 billion per year of loss from counterfeit goods, pirated software, and theft of trade secrets. They also note that this estimate does not include the full cost of patent infringement, and these estimates are only for US companies. There are hundreds of multinational companies, including some in which we are investors, that have experienced trade theft in some way. Siemens, IBM, and Lockheed Martin are just some of the bigger names that have recently highlighted cases. While IP theft can be costly for large companies, it can be devastating for smaller companies. In January, a small US wind technology company called AMSC won their case against Sinovel Wind Group of China, the second largest wind turbine producer in the world before this lawsuit. In total, the theft cost AMSC $1.2 billion in total revenue and over 600 jobs were lost.
While President Trump and his team have chosen a risky strategy to bring China to the negotiating table, companies around the world could stand to benefit greatly from fairer Chinese trading policies. A prolonged trade war will not benefit anyone and might even cause short term pain in some industries. However, the US has tried in the past to force China to adjust their trade policies without success. Now may be the time to force China’s hand as President Xi will be under pressure to produce steady economic results, in his first year after changing the constitution to extend his term. With their WTO status also under consideration, China will not be comfortable with the spotlight on their trade policies for long. Much is at stake during these next few months but all companies, and their investors, outside China could benefit greatly from change in Chinese trading policies.
- Earnings season begins.
- Italy and Germany continue talks on building a coalition government. The pressure on Angela Merkel is intensifying each passing day as the biggest economy in Germany is still without a working government.
- Trade talks will be closely monitored throughout the world.
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