Rarely have I seen such a disconnect. The US Congress is moving full steam ahead on anti-China protectionism, and no one seems to care – especially investors in ever-frothy financial markets. “In the end, America always does the right thing” is the common refrain when this matter is discussed in business circles, amongst government officials and policymakers, and even in academic forums. Taking their cue from such a blasé assessment of protectionist risks, liquidity-fueled investors – from China’s A-shares to America’s Dow – see little to worry about on the trade front.
US protectionism: risks not being discounted
Our global team of market strategists at Morgan Stanley is in broad agreement that protectionist risks are not being discounted in the markets they follow. That conviction runs deep throughout our coverage of all major asset classes – equities, bonds, credit, and currencies. US equities are leading the pack in the denial game.
As David McNellis and Henry McVey noted recently, the US market’s recent outperformance has been concentrated in the mega-cap S&P 100, companies which generate 34% of their revenue outside the United States. Teun Draaisma underscores a similar trend in European cyclicals, like capital goods producers, which are trading at a P/E premium of some 25% higher than the rest of the market. Naoki Kamiyama concurs with respect to Japan, noting the resilience of technology and auto equities – as well as the conviction that Japan is not the target of Washington’s China bashers.
Our emerging market equity strategists stress similar conclusions, although Jonathan Garner notes the developing world may have more potent defenses to ward off an external shock – namely, outsize foreign exchange reserves and reduced reliance on external portfolio funding of their balance of payments. Our Asian team is particularly struck by the denial of protectionist risks; our regional strategist, Malcolm Wood, ascribes this to a “boy-cries-wolf-syndrome,” whereas China strategist Jerry Lou marvels at the excessive levitation of the domestic A-shares as Washington moves closer and closer to imposing sanctions on Chinese imports.
US protectionism: no effect on bond markets
The fixed income view is virtually identical insofar as an assessment of US-led protectionist risks are concerned – they are simply not in the price. The absence of any deterioration in the inflationary premium – a classic repercussion of trade frictions – is viewed as prima-facie evidence in support of this conclusion.
Yet, as both Jim Caron and Dick Berner note, the recent tightening of TIPS spreads and the concomitant flattening of the US yield curve hardly discount any inflationary pressures that might arise from protectionism. Greg Peters bemoans that no one seems to care about this in the US credit space. This is consistent with a similar verdict rendered by his European counterpart Neil McLeish, who argues that tight credit spreads are an outgrowth of expectations of continually low default rates that do not allow for any possibility of a narrowing between the return and cost of capital for low-quality borrowers.
Yet that’s precisely the outcome that would undoubtedly occur in a protectionist scenario. Stephen Li Jen rounds out the picture, noting that an outbreak of serious China bashing would be a uniformly negative event for the dollar, with most of the action concentrated on the Asian axis of foreign exchange markets. The dollar’s recent weakness, in his view, is simply a continuation of a five-year gradual decline – a far cry from a much sharper adjustment that might occur if a capital-deficit nation like the US lashes out against one of its major foreign lenders.
US protectionism: why investors are unconcerned
So, whatever the asset class, wherever the region, the verdict is pretty much the same – financial markets are currently ascribing almost no chance to a protectionist surprise. As I speak with a broad global cross section of investors and business executives, I get a similar impression. The electronic polling we conduct at major investor conferences around the world reveals the same sense of disbelief in a protectionist endgame.
Two reasons are usually cited in support of this conclusion: First, there is a strong belief that the US will eventually come to its senses and do the right thing by living up to its role as the architect and leader of the pro-trade, post-World War II global economic order. Globalization is viewed as America’s invention, whereas protectionism is seen as the antithesis of Washington’s global vision. Second, the “boy-cries-wolf” critique that Malcolm Wood notes above is very much alive and well in financial markets today. The protectionist rumblings of the last couple of years have been just that – more bluster than action. Investors stress that every time they have tried to play this risk as an actionable outcome, they have lost money. The appetite to chase another protectionist scare is heavily influenced by such misadventures in the markets.
So what makes me so smart? Or perhaps, to put it more delicately, do I really have a better read than the markets on what the US Congress is up to? My answer is that it is not an either/or proposition. This is not a case of the binary outcome – globalization or protectionism. Instead, it is much more about probabilistic risk assessments of a wide range of possible outcomes. With the help of our team of market strategists, the way I read the broad consensus of investor sentiment right now is that virtually no risk is being assigned to a protectionist endgame. My experience in Washington over the past three months – three separate appearances in front of the Congress and considerable consultation with congressional and Administration senior staffers – leads me to conclude that this risk assessment is far too sanguine. I continue to think that there is a 60% chance that a WTO-compliant bill aimed at curbing the trade deficit with China will be passed by a veto-proof majority in both houses of Congress by the end of this year. Even if I am wrong by a factor of two, for my money, the markets are still far too relaxed on this key issue.
I certainly don’t profess to be a political vote counter, either. We have a team in Washington that is far more adept at that than I am, and we also rely on the insights of several consultants. Their conclusions are also much more cautious on the protectionist risk scenarios than those currently being discounted in financial markets. Of course, there’s never a sure thing when it comes to assessing Washington risk on any issue. The smokescreen of mixed signals is endemic to the place. The recent compromise between the Bush Administration and congressional Democrats on labor standards and trade agreements is classic in that regard. Some view this as a sign that the Democrats are retreating to the high ground of the protectionist debate. Others claim this represents a White House capitulation that is aimed at tempering more extreme actions by the Congress. I am more sympathetic to the latter interpretation but concede that anything is possible in the classic grey area of Washington ambiguity.
In the end, I stand by my view that Congress is merely picking its spots. It does not want to be labelled as one-sided in the trade debate. Compromise on the labour standards issue underscores that point. At the same time, I see no let-up in efforts to single out China. The latest such initiative in this regard is the Hunter-Ryan bill currently under consideration in the House (H.R. 782), which treats currency manipulation as a subsidy that can be remedied by broad-based, WTO-compliant countervailing duties.
On a different track, Congress is also moving forward on the Davis-English Bill (H.R. 1229), which would nullify the special dispensation from trade rules currently given to non-market economies like China. Both of these bipartisan initiatives have broad support in the House. And our sources suggest that there is plenty more in the congressional hopper – in the Senate as well as in the House – insofar as anti-China legislation is concerned. Ultimately, if the protectionist-risk scenario becomes a legitimate threat, Congress will have to pick the horse it wants to ride and solidify support around one approach. I suspect that this narrowing process is now under way and is likely to reach a conclusion by the end of this summer.
US protectionism: what it means for investors
So what’s an investor to make of all this? I would stress three key conclusions: One, an outbreak of protectionism is not in the price of world financial markets in any way whatsoever; if the odds start to shift, most major asset classes – equities, bonds, credit, and currencies – would be highly vulnerable. Two, these risks are being dismissed not just because they have been a bad bet in the past several years but also because of the deeply held perception that the United States ultimately always does the “right” thing. Three, the odds of anti-China trade legislation being enacted by the US Congress are high and rising, in my view; this could well become more apparent after the second installment of the Strategic Economic Dialog between the US and China, slated for May 22-24 in Washington DC.
Should those high-level talks produce another set of non-results – very much the risk – I suspect Congress will most assuredly up the ante. For financial markets steeped in denial, that could be a most bitter pill to swallow.
By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley’s Global Economic Forum