Red flags over Osaka. The Group of 20 summit in Osaka gave investors an excuse to buy riskier financial assets. As a result, world stocks are their highest since September, and the chances for aggressive interest-rate cuts by the Federal Reserve have been pared back a little. But it would be unwise to put much more weight than that on the trade truce that was reached in Osaka between the U.S. and China. This is what has happened since 2016 to the broad MSCI All-Country World Index, an MSCI index that excludes U.S. stocks and one that only tracks American equities:  A remarkably synchronized global rally from the moment that President Donald Trump was elected bifurcated once trade hostilities broke out in earnest in the spring of 2018. Since then, world equities have been flat, with gains for the U.S. matched almost perfectly by losses for the rest of the world. The market is still pricing an outcome in which the U.S. wins a trade war. How plausible is this? The implication is that there is a fixed pie, from which U.S. companies can now take a higher share. The concern must be that trade hostilities might reduce the size of the pie — and of course we should still question whether the U.S. can "win" as clearly as seems to be suggested. There are great reasons to question these assumptions. One problem is currency. A weaker dollar makes life easier not only for U.S. exporters, but emerging markets as well. It also makes life easier for China, whose currency is still pegged to the dollar. For all the discord between the two nations, their fates remain intertwined. As China has had much faster inflation than the U.S. this decade, while the dollar has generally been strong, maintaining the link to the dollar has required China to allow its currency to become much less competitive. I put together the following chart using widely cited real effective exchange rates (taking into account differences in inflation) on a trade-weighted basis. On this basis, we can see that China has had the sharpest appreciation over this time, tracking the dollar. Meanwhile the yen and the euro have become more competitive:  A big devaluation of the Chinese currency at this point is not in the cards. For a start, it would wreck trade negotiations with the U.S. But the contradictions of China's currency run deeper. George Magnus, in this month's book club selection, "Red Flags," goes so far as to say that China is in a "renminbi trap." He points to wide evidence of capital flight in the last few years, showing that confidence in the yuan's peg to the dollar is weak, at least among China's wealthier citizens. And he also points to the impossibility of what China is trying to achieve. He refers to Canadian Nobel laureate economist Robert Mundell: ...who reasoned that you cannot have a pegged exchange rate, an independent monetary policy and an open capital account all at the same time. Known as the impossible trinity, it allowed Mundell to warn that monetary policy becomes ineffective when there is full capital mobility and a fixed exchange rate, and you can only ever run two of these three policies. China at present is following Mundell's advice by trying to limit capital flows, but this makes it that much harder to maintain the currency reserves needed to defend the exchange rate. And China's attempts to stimulate the economy with extra credit would require it to keep more reserves to defend the currency. If renminbi-denominated assets kept growing at a double-figure percentage rate, while reserves were more or less stable, then Magnus says that "confidence in the exchange rate could come unhinged quite easily." He finds a devaluation of 25% to 35% conceivable, and the chart above shows why China might want such a thing. But it would be taken as an act of extreme aggression on the trade front. An alternative would be to allow the currency to float, he writes: But this would require the government to cede control over the currency to the global foreign exchange market, and a government for which 'control' is a lodestone seems very unlikely to do that. This is not a problem that will go away. However, the immediate response to the news from Osaka has been to strengthen the dollar a little bit, and for markets to cut back a little on their expectations for steep rate cuts from the Fed between now and the end of the year. If we assume that it is hard for the Fed to go any further than recent expectations, then it follows that any surprises will strengthen the dollar, not weaken it, while there are limited chances for the dollar to depreciate further. If this proves to be the case, then the "renminbi trap" becomes at least as much of a problem for China as any protectionist barriers mounted by the U.S. My Bloomberg News colleagues Joe Weisenthal and Tracy Alloway had a fascinating chat with Hyun Song Shin, economic adviser and head of research at the Bank for International Settlements. The title of their podcast episode says it all: "Why a Strong Dollar Causes the World Major Pain." When the dollar is strong, life gets harder for everyone. He also introduced a way to trace globalization, or the importance of global value chains to the world economy, by showing the ratio of world goods exports to world GDP. After a sharp rise, this ratio tanked during the financial crisis, never recovered its peak, and started a long decline years before talk of a trade war gained momentum:  Hyun Song Shin pointed out that this has much in common with the health of the global financial sector. The great bulk of trading volume is financed by banks, and in dollars. Even with rock-bottom bond yields, therefore, the strong dollar and the weak banking systems around much of the world mean that the financial conditions for trade have been very tight for years. Weisenthal suggested on the podcast that this chart looks a lot like a relative performance chart for emerging-market stocks over the same period. He's not wrong, and this is not a coincidence. Here is how emerging markets have performed relative to developed markets over the same period, according to MSCI:  Whether or not the U.S. manages to "win" a trade war, it seems a very fair bet that emerging countries, still building middle-class internal markets and largely dependent on exports for growth, will lose. But that brings us to another area where the current market assumptions could be wrong. China very much has it within its power to hurt the U.S., even without resorting to tariffs, because the government's control over the Chinese corporate sector enables it to engineer a sharp drop in the goods it imports from the U.S. This chart from Bank of America Merrill Lynch shows that may be already happening:  The decline in Chinese imports from the U.S. could yet cause serious problems for the American economy, while cushioning others. BIS work on value chains, also featured in the podcast, also makes it clear that China is now very central to the global trading system. That means that any problem for China's economy is a problem for everyone.  This is a deep and technical issue that does not permit a simple solution, even if that is what market pricing currently implies. Meanwhile, some losers are plainly visible, and not only in the semiconductor sector that rallied on Monday, and which is evidently very closely tied to the fate of China. Bank of America Merrill Lynch pointed out that the drop in Chinese tourism to the U.S. since the beginning of last year has harmed the performance of U.S. luxury retailers. Normally, a time of economic expansion like this would not be good for discounters — but the reverse has been the case since trade hostilities broke out last spring:  It is also very important to note that the market is currently betting that things will not be too bad for those companies most affected by trade conflict with China. The following chart, also from Bank of America Merrill Lynch, shows that the sectors most exposed to Chinese trade have, as might be expected, seen the sharpest declines in earnings per share. But they have also seen a rise in their prospective earnings multiples, meaning that investors are betting that those earnings forecasts are too gloomy:  Finally, of course, there is also a risk that the trade war could spread. Logically, Vietnam is a country that could benefit from a fall from grace for China. Its economy looks very much like China did 20 years ago. In textiles, traditionally an industry in which growing countries start their drive for growth, its share of exports to the U.S. has risen impressively:  Small wonder then that Vietnam is now also arousing anger from the U.S. president over its trade practices. For investors, the bottom line has to be that this rally in equities continue to suffer from contradictions. A successful trade war — even a peaceful victory — for the U.S. will mean fewer rate cuts and a stronger dollar, which would create many of the same problems that tariff barriers can cause. An unsuccessful attempt to beat China into submission is a risk that has already roiled markets for more than a year. It has not gone away.
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