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Michael Cembalest discusses his latest Eye on the Market. Topics include the underappreciated risks of Chinese retaliation against US companies doing business in China, and how a full-blown trade war and military conflict are far from inevitable

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Michael Cembalest

You know, there are some people in the administration that believe that it is possible to gain the upper hand in a trade war, when you are the country that is doing all the importing, believing that that gives you leverage, because the other side has got a lot to lose, in terms of their exports. In a theoretical world, maybe, but not the world we live in, where things are more complicated.  

Over the last decade, U.S. companies have made a lot of investments in their Chinese subsidiaries. And if you include, in the concept of the trade deficit, the in-country sales of subsidiaries, the U.S. trade deficit almost disappears. In other words, U.S. companies are doing almost as much business, in China as Chinese companies are doing in the U.S., but through their subsidiaries rather than via exports.

And Apple, Intel, QUALCOMM, Boeing, Micron, Broadcom, Texas Instruments, those are examples of some of the companies with the largest Chinese sales. And these companies have some of the largest investments, in China. They are some of the largest employers in the U.S., and capital spenders in the U.S., and their shares are held very widely in defined benefit and defined contribution plans. So, the U.S., I think, has more to lose, in the trade war, than some people in the administration may think.

The trade war is just one part of a broader rivalry between China and the U.S. And I just wanted to spend a minute on something I have been working on for the last few months. There are some that believe that the Chinese–U.S. military conflict, not just a trade war, but that military conflict is inevitable. And in a survey that was done last year, by an organization or prominent Chinese Americans, around one-third of Chinese business leaders and policy experts thought that a war with the U.S. was very likely or somewhat likely a shooting war. 

Maybe. But there is a lot of economic pressure on China and the U.S. to find common ground. What we did it – and you can see this in this week’s Eye on the Market, we looked at adversaries of the past 100 years and at the linkages between them. We looked at things like bilateral trade. We looked at bilateral foreign direct investment. And we looked at bilateral central bank holdings, of the other country’s debt. And the economic linkages, between the U.S. and China today dwarfs the linkages between France and Germany, and the U.K. and Germany, in the ‘30’s; between China and Japan in the 1930’s; between the U.S. and Russia in the 1980’s; and certainly, dwarfs the relationship between the U.S. and Iran and India and Pakistan, and things like that. 

So, when you look at the magnitude of these economic linkages, I am not, by nature, an optimist, but they do suggest, to me, that there is a lot of pressure to find some kind of compromise and and avoid a shooting war or a full-blown trade war.

As for emerging markets, they outperformed developed markets by 20% in 2016-2017, and are now underperforming by two to 3%. So, they are giving back around a tenth of the outperformance of the last couple of years. 

I do find it interesting that there is so much discussion about Argentina and Turkey. Argentina is not even in the emerging markets equity index. It was thrown out a few years ago, and moved into a frontier index, alongside Lebanon and Kenya. And Turkey only has a 1% weight in the index. 

So, there is some pressure, obviously, on the emerging markets, with rising interest rates, and rising dollar and rising oil prices, but when you look at the degree to which Argentina and Turkish fundamentals are affecting the headlines, I think there is a little bit too much focus on those two countries. And the sell off to the rest of the countries, has been somewhat orderly, which is a sign of a little bit of a maturing market.

As a reminder, now that there is so much discussion about Argentina, as I mentioned, it is not even in the emerging market equity universe that most managers invest in. It has spent the last three years borrowing a ton of money, and it has defaulted on its international debt seven times since its independence in 1816. 
And one of the things that we show here, in the piece this week, is a cluster model that shows just how risky and different Argentina is, for investors. We look at competitiveness, regulation, investor protections, labor markets, ease of doing business, and we plot all the large countries in the world, on this little map. And the closer countries are to each other, the more similar they are. And Argentina is off in the stratosphere, on the fringes of this chart, near countries like Bangladesh, Zimbabwe, Ethiopia, and Pakistan. 

And again, just as a reminder, this is looking at things like property rights, government regulation, judicial independence, pay and productivity, in the labor force, ease of doing business, economic freedoms, and so, I think people should keep in mind that Argentina is a little bit of a special case here, and not indicative of the fundamentals, in terms of external borrowing, or current account financing risk, of the rest of the EM universe.
Only in a world of financial oppression, by central banks pushing down rates, could a country like Argentina have issued a one-hundred-year bond, which they did last year, and which was oversubscribed. That bond is down 15 to 20% from its peak a few months ago, and there is echoes here, from 2001, when Argentina also issued new debt, just a few months before defaulting on it. 

My wife, Rachel, ran J.P. Morgan’s Emerging Market Capital Markets Division back then, and she led the syndicate that originated that set of bonds. I was a buy side investor at the time, and gave her some grief about it. But she has since retired. So, if you bought the one-hundred-year Argentine bond issued last year, you are on your own. 
Michael Cembalest’s Eye on the Market offers a unique perspective on the economy, current events, markets, and investment portfolios, and is a production of J.P. Morgan Asset and Wealth Management. Michael Cembalest is the Chairman of Market and Investment Strategy, for J.P. Morgan Asset Management, and is one of our most renowned and provocative speakers. For more information, please subscribe to the Eye on the Market, by contacting your J.P. Morgan representative. If you would like to hear more, please explore episodes on iTunes or on our website. 

This podcast is intended for informational purposes only and is a communication on behalf of J.P. Morgan Institutional Investments, Incorporated.  A member of FINRA and SIPC. View may not be suitable for all investors, and are not intended as personal investment advice, or as a solicitation, or recommendation. Outlooks and past performance are never guarantees of future results. This is not investment research. Please read other important information.

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