Thursday, 24 January 2019

Trump's tariffs threaten Asian credit

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  • Jonathan Rogers
Higher US inflation will reprice emerging-market risk, says Jonathan Rogers

The cosy relationship between a core group of Asian credit markets may be about to come to an end. The cost of default protection for China, Malaysia, the Philippines, South Korea and Thailand has been close to parity for a long time, but CDS markets are now digesting another input from President Donald Trump.

The threat of tariffs targeting exporters of steel and aluminium to America should resonate long and hard in Asia, which has built its more than half century of profound economic growth around exporting.

Asian stock markets predictably melted after the heresy of tariffs – 25% on steel and 10% on aluminium – was first mooted, but recovered last week when a measure of repentance was displayed in the form of cherry-picking which countries would be exempt from US tariffs (so far, Canada and Mexico).

The response from regional credit analysts was to suggest that the proposed tariffs would have little impact on Asia’s biggest steel exporters, China and South Korea, given that their income from exporting to the US is a relatively small percentage of GDP: around 1%.

That could be missing the point. Trump has already raised the spectre of the notorious protectionist legislation passed in 1930 courtesy of Senator Smoot and Congressman Hawley – a rather comic duo if you take a look at a photograph of them (Laurel and Hardy minus the laughs). After the stock market crash of 1929 that toxic trade bill took much of the blame for the Great Depression of the following decade.

Smoot-Hawley was comprehensive, covering 20,000 imported goods. I doubt Trump’s protectionist bluster will translate into anything of that scale, but the risk of a trade war is certainly there.


THE IMMEDIATE TAKEAWAY, however, is added inflationary pressure in the United States.

The US steel industry has insufficient capacity to absorb the sudden shift in demand and it seems likely that big steel-consuming industries from suppliers of canned goods to cars, planes and heavy machinery will raise prices for end users rather than cutting costs or profit margins as demand for American steel surges. Headline CPI will rise as a result, and with it, US Treasury yields.

I still believe that Treasuries are due an upside correction in the face of rising global stock market volatility and the re-emergence of the risk-off mindset, despite the spike in US yields of recent months. Over the longer term, though, the Bill Gross theory that the 30-year-old bull market in US Treasury bonds is over might well be right: we are in a rising rate environment thanks to inflationary pressure.

That in itself isn’t necessarily a bad thing. Indeed it’s ironic that market pundits have for years been bemoaning the lack of inflationary pressure in the global economy. The Bank of Japan’s mission statement, for example, has been to initiate inflationary pressure in the country’s economy. Even now, the US economy is undershooting the Federal Reserve’s explicit inflation target.


WHEN ALL IS said and done, it’s a case of being careful what you wish for.

The resurgence of inflation is just what the debt-laden global economy requires, to deflate the nominal value of that debt pile. And as the US yield curve steepens, banks which engage in dollar lending will cash in handsomely on the positive carry which accrues as a result.

But I suspect that the consequent pressure on dollar interest rates will take a severe toll on Asian economies, which will be forced to raise rates in lockstep with the Fed.

The region’s domestic bond markets have been the major beneficiaries – if that’s the right word – of the global quest for yield, and many have experienced unprecedented levels of foreign ownership; Indonesia’s is a prime example, where a large portion of the rupiah government bond market is in foreign hands.

A “normalisation” of US rates poses the risk of sudden capital flight, pressure on the foreign exchange rate and the erosion of central bank reserves in the futile defence of currencies. In the process, debt service of foreign currency-denominated paper becomes onerous.

I’m not suggesting that a re-run of the Asian financial crisis is on the cards. The region’s currencies are no longer artificially pegged to the US dollar as they were in the late 1990s when that crisis erupted. Corporate balance sheets are less leveraged than they were back then, maturity profiles are longer and interest rate and foreign exchange risk hedging is more prevalent.

But as the “Make America Great Again” juggernaut starts to roll, stirring inflationary and rates pressures in its wake, the big shift back to US assets leaves relatively high-yielding emerging markets looking highly vulnerable. Asia, with the notable exception of Japan, sits high on that list.


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