Special Trade War Update
The Quarterly Update series was created to demystify Economics and Investing. First published on March 30, 2017 and last updated on April 18, 2018.
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Special Trade War Update is a companion piece to my essay "The Case for Active Investing: Investing During the Trump Era," which I published in November 2016 after the Presidential Election.
Act 1. U.S. Domestic Political Economy
Battlefield: Middle Class
Donald Trump campaigned on an America First platform called Make America Great Again. Trump's populist message echoed strongly the grassroots economic interests of William Jennings Bryan and the Election of 1896. The President describes it quite aptly. 2016 was the biggest loss in American political history.
"The Forgotten Men and Women"
This American Carnage stops here and stops right now. The forgotten men and women of this country will be forgotten no longer.
"While the politicians prospered, the jobs left and the factories closed . . . Rusted out factories scattered like tombstones throughout the country . . . We have spent trillions overseas while our infrastructure crumbles."
From this day forward, it will only be America First. We will bring back our wealth, and we will bring back our dreams.
January 20, 2017: It was a very large crowd for the Inauguration of the 45th President of the United States, Donald J. Trump.
February 28, 2017: First Speech to the Joint Session of Congress
January 30, 2018: President Trump's First State of the Union Address
The Road to the White House
Remember How You Felt at 7:30?
November 8, 2016
Rust Belt Flipped from Blue to Red
Rust Belt Revolution. Trump won the Presidency in 2016, because he pulled out shocking upset victories in Michigan, Pennsylvania and Wisconsin, albeit at razor thin margins*
Trump flipped Ohio, a must win state for Republicans, in a rout
Source: https://www.nytimes.com/elections/results/president
Paving The New Road to the White House
All of mainstream media, even conservative newspapers such as Wall Street Journal, expected Secretary Hillary Clinton to easily win the 2016 Presidential Election. This consensus influenced some hubris in the Clinton campaign. For example, it was widely reported that Hillary Clinton rarely visited Michigan and that she skipped Wisconsin altogether.
The Political Economy of Steel and Aluminum
March 2, 2018
Secretary Ross set the stage by telling CNBC that the Steel industry had lost 70,000 jobs from 1998 to 2016. Secretary Ross also shared this: “Every company at our session yesterday said that they will be reopening plants and rehiring people. Hundreds of millions of dollars of capital investment is coming online. We need to be exporting products, not exporting our jobs.”
The United Steelworkers Union has ~600,000 members in the U.S.
Trump's three most shocking victories came with a combined margin of victory of 77,744 votes - Less than 1% of the votes
Less than 100,000 votes determined the 2016 Election
The Secretary of Economic War on American Economic Nationalism
The President shows deference to four men in his Administration. They are Vice President Mike Pence, Secretary of Defense General Jim Mattis, Secretary of State Rex Tillerson, and Secretary of Commerce Wilbur Ross.
Prosperity, Self-Interest & Protectionism
After World War II, in our own self interest, instead of leaving Europe in ruins, the United States gave $140 billion (2017 dollars) to help rebuild the physical infrastructure of these countries. Additionally, the United States made unilateral economic concessions, opening up our domestic markets to foreign produced goods, in order to prevent future war but also contain the spread of Communism.
While Secretary Ross acknowledged the Marshall Plan as good strategy "in early days," he points out that policymakers never put a time limit on these economic concessions, and that, over time, America's advanced its foreign policy interests at the expense of America's working and middle class. Secretary also identified clear and egregious examples of unfair trade practices harming American workers still today.
For example, to import a car into the U.S., we have a tariff of 2.5%. If we want to sell an American car into the EU market, the tariff is 10%, into China it's 25%
Name one country less protectionist than us. There is no answer, because we are the least protectionist country in the world.
What has been going on is that other countries have been picking away at us and dumping their materials here, and we have not been fighting back. Trump will keep his *Promise* to fight back.
“While it is true that only a small percentage of steel is needed in military production, we are down to one domestic producer of certain advanced alloys. This is a dangerous thing. It is an Oversimplification to say that Defense is only a few percent. There is not enough military business is on its own for steel mills to be profitable and keep going.”
"Economic Strength is Military Strength"
Steel and Aluminum Industries have been designated as strategically important to U.S. National Security
March 1, 2018: CNBC calculated that U.S. listed steel stocks gained $2.3 billion in equity market capitalization. The S&P 500 Index lost $328 billion in capitalization. Interesting to note that the market value gain of the steel industry was 0.7% of the loss of the market basket.
Broad Impact, but Trivial Impact
The Secretary of Commerce was ready to shame free traders. To consumers, these tariffs will impact the price of consumer goods by pennies (I calculate 0.2% to 0.5%) while saving jobs and likely creating thousands more.
Dimensionalizing Fairness
March 2, 2018: Commerce Secretary Ross explains the impact to the American consumer. On average, the steel and aluminum tariffs will increase the price of certain goods by 0.2% to 0.5%.
Section 232 of the Trade Expansion Act of 1962:
Framework to assess the impact of imports on national security
Under the test of National Security, the Secretary identified critical metals, alloys and other materials which, after years of global overcapacity, have only one remaining domestic producer.
The blanket tariff on Steel and Aluminum is designed to address the underlying massive overcapacity in China, by closing known tariff loopholes through techniques such as trans-shipping through markets without the same trade protections.
January 11, 2018: The Effect of Imports of Steel on the National Security
On Steel
In 2016, U.S. steel production was 78.6 million metric tons and U.S. capacity was 113.3 million metric tons, which represents a 69.4 percent capacity utilization rate. If current import trends for 2017 continue, continued imports without any action are projected to be 36.0 million metric tons, an increase over 2016 of 6.0 million metric tons. Even with U.S. demand projected to increase to 107.3 from 99.8 million metric tons, increased imports mean U.S. capacity utilization is forecast to rise only to 72.3 percent, a non-financially viable and unsustainable level of operation.
On Aluminum
The Secretary recommends that the action taken to adjust the level of imports must be in effect for a duration sufficient to allow necessary time and assurances to stabilize the U.S. industry. It takes up to nine months to restart idled smelting capacity. Market certainty is needed to build cash flow to pay down debt and to raise capital for plant modernization to improve manufacturing efficiency.
January 11, 2018: The Effect of Imports of Aluminum on the National Security
Archive | Past Examples of Section 232 Cases
Act 2. Retaliation
Act II. Retaliation was published in April 2018
Special Trade War Update | Act II. Retaliation
The United States, under President Trump, has demanded the following from China:
ㅡ Take Care of North Korea
ㅡ Stop Dumping Steel and Aluminum
ㅡ Reduce Trade Surplus by $100 Billion
ㅡ Stop Stealing Technology
"The Chinese have been shrewd practitioners of Realpolitik and students of a strategic doctrine distinctly different from the strategy diplomacy that found favor in the West." -- Henry Kissinger
Henry Kissinger wrote this seminal book on the History of China
Henry Kissinger was a Jewish refugee who fled Nazi Germany as a child. Kissinger practiced Realpolitik in his roles as National Security Adviser (1963 and 1973) and the Secretary of State (1973 to 1977). He is credited with all of the following foreign policy achievements: (1) Ushering detente with the Soviet Union (2) Opening dialogue with China and (3) Ending United States involvement in the Vietnam War. Friends at the J.P. Morgan Private Bank gifted this book to me for the 2012 Summer Reading List.
China Was the Original Superpower
And Was for Most of History
Cultural and Economic Superiority without American-style Universalism
However, China's Self-Imposed Cultural and Geographic Isolation In The Middle Kingdom Created A Disastrous Bubble
At its ultimate extent, the Chinese cultural sphere stretched over a continental area much larger than any European state, indeed about the size of continental Europe. Chinese language and culture, and the Emperor's political writ, expanded to every known terrain: from the steppelands and pine forests in the north shading Siberia, to the tropical jungles and terraced rice farms in the south; from the east coast with its canals, ports, and fishing villages, to the stark deserts of Central Asia and the ice-capped peaks of the Himalayan frontier. The extent and variety of this territory bolstered the sense that China was a world unto itself. It supported a conception of the Emperor as a figure of universal consequence, presiding over tian xia, or "All Under Heaven."
Tian Xia Disrupted
As late as 1820, Qing Dynasty China had the World’s #1 economy with GDP comprising 30% of the world’s total. But Economic Superiority alone was insufficient to preserve the Status Quo.
Unknownst Advances in Western Technology, such as Steam Power & Mass Manufacturing gave Invading Barbarians the Disruptive Military Firepower to Open China and Demand “Free Trade” to Pedal Opium for Silver
Opium War I: 1839 to 1842
"The Clash of Two World Orders"
Opium War II: 1856 to 1860
Left: "The Bridge of Kalikao," September 21, 1860. The French and English forces took this bridge, thereby conquering Beijing and winning the war. In the Upper Right: The Capture of Ye Mingchen after Canton. In the Lower Right, the signing of the Treaty of Tientsin, which ended the Opium Wars.
Chinese Realpolitik: Wei Qi and The Long Game
"In general, Chinese statesmanship exhibits a tendency to view the entire strategic landscape as part of a single whole: good and evil, near and far, strength and weakness, past and future all interrelated. In contrast to the Western approach of treating history as a process of modernity achieving a series of absolute victories over evil and backwardness, the traditional Chinese view of history emphasized a cyclical process of decay and rectification, in which nature and the world can be understood but not completely mastered."
Instead of chess or checkers, the Chinese play Wei Qi, a game of strategic encirclement
"Go" is a game about strategic encirclement, precision placement, and movement with long term objectives in mind. It is called "Wei Qi" in Chinese and "Badut" in Korean. Go is a complex game with very simple rules.
"Know Thy Place"
After Suffering Humiliating Defeat to Western Powers in the Opium Wars, China was Relegated to Second Tier Status
China has a long way to catch the United States which emerged as the Global Superpower in the middle of the 20th Century
Normalization
In the Realpolitik school of International Relations, each Nation is responsible for its own economic and military security in a "Realist" world of global state anarchy
Since World War II, the world has experienced an usually long period of peace, Pax Americana. Since the End of the Cold War, the world has experienced tremendous wealth creation under the United States, which emerged as the sole global Superpower. No country has been as Dominant as the United States in Military, Economic and Technological strength, since, well, China.
China has the world's largest population and access to significant sums of capital. However, China must catch up in advanced technology ㅡ if China is to reclaim Tian Xia
Meanwhile, China faces serious challenges, including the welfare of the aging population and rural political unrest. China's ability to address both vulnerabilities requires continued growth in China's economic engine.
China trails the United States in hard military power. China has a large standing military capable of territorial self-defense, but has no ability to project force outside of its boundaries. The Chinese will avoid any military confrontation during this Trade War.
Established in Confucian principles, and perfected over centuries, the Chinese system of meritocratic state bureaucracy staffed by the country’s elite creates ㅡ Institutional Memory ㅡ a critical success factor in Realpolitik
What Does China Want? ㅡ Normalization. Respect. Return to Global Leadership.
In his biography, President George W. Bush shared a side conversation that he once had with China's former President Hu Jintao (March 2003 -March 2013). Bush asked Hu what kept him up at night. Bush reported that Hu deadpanned, "creating 25 million jobs per year."
How Has China Done? ㅡ Foreign Exchange Reserves of USD $3 Trillion in 15 Years
The coffers are full.
China joined the World Trade Organization in 2001. China hosted the Summer Olympics in Beijing in 2008.
The Declining Barbarian
Populist backlash from America's Heartland elects Donald J. Trump
It's the type of political upheaval that the Chinese can understand
When facing the uncertain future, we turn to History. The Chinese are students of History.
Xi
Xi Jinping (born 15 June 1953) is a Chinese politician currently serving as General Secretary of the Communist Party of China, President of the People's Republic of China, and Chairman of the Central Military Commission. As Xi holds the top offices of the party, the state, and the military, he is sometimes referred to as China's "paramount leader"; in 2016, the party officially gave him the title of "core" leader. As General Secretary, Xi holds an ex-officio seat on the Politburo Standing Committee of the Communist Party of China, China's top decision-making body. (That's a mike drop. From Wikipedia).
Lifetime Appointment Can Play the Long Game
Xi will Appease & Curry Harmony with the U.S.
The Trade War creates a platform for Xi to bring China into a position of greater Global Prestige. China will earn respect for its forbearance. The World is watching, and President Trump is providing a heightened media platform for coverage.
"To give them . . . elaborate clothes and carriages in order to corrupt their eyes; to give them fine food in order to corrupt their mouth; to give them music and women in order to corrupt their ears; to provide them with lofty buildings, granaries and slaves in order to corrupt their stomach . . . and, as for those who come to surrender, the emperor (should) show them favor by honoring them with an imperial reception party in which the emperor should personally serve them wine and food so as to corrupt their mind. These are what may be called the five baits."
Trade Deficit
China should understand the optics of President's Trump's demands to reduce its Trade Surplus with the United States. Shown below, China's exports to the U.S. continue to surge.
China's Exports to the United States are shown in Blue, and increased by 10% in 2017. Note that Chinese Exports to the US increased at the same time that the Chinese Renminbi strengthened from 6.9 to 6.2 RMB per U.S. Dollar.
U.S. Energy Renaissance
The United States will Eclipse both Saudi Arabia and Russia as the World's Most Important Energy Producer. For example, the associated gas production from shale oil is abundant, solidifying the United States as lowest cost producer of LNG.
Most LNG around the world is sold using a price formula linked to Brent crude oil at a ratio of 6:1. For example, at $70 Brent, LNG is priced at $11.66 per one million British thermal units. However, as an alternative supply source, U.S. Export LNG can be purchased for less than $8 per unit. The U.S. Natural Gas price advantage only increases with higher oil price environments.
Fortune Cookie #1: China will purchase United States Liquefied Natural Gas
Buying U.S. Export LNG is an Easy Bait for China
North Korea
Fortune Cookie #2: China will defuse Rocket Man
On March 28th, one month before the first Inter-Korean Summit since 2007, and two months before the historic summit with the United States, North Korea's Kim Jong Eun, the Dear Leader, took an armored train to Beijing to meet with Xi Jinping
Kim Jong Eun's visit to Beijing reminded me of Henry Kissinger's story of Kim Il Sung's trek to China and the Soviet Union in 1950. Kim Il Sung wanted to force Korean Reunification by invading South Korea, but he first needed get approval from China and Russia. Per Kissinger's account, neither Mao nor Stalin explicitly forbade Kim from invading South Korea, and so, Kim Il Sung took advantage of the ambiguity and started the Korean War. As a result, North Korea put China in a hot war against United States, the last thing Mao wanted.
There was likely no ambiguity in the March 2018 Summit between China and North Korea. I think Xi said: Stand Down.
North Korea has violated international norms and treaties in its unrelenting pursuit of building nuclear weapons. Hwasong-15 and its breakthrough range puts the United States at existential risk, which is unacceptable to the current Trump administration.
Technology
Fortune Cookie #3: China will agree to normalize its technology practices
Understand Your Enemy
We translate Sun Tzu's The Art of War to read "Know Your Enemy." Interestingly, in Chinese, a better translation is "Understand Your Enemy."
"China’s long-term time horizon is legendary. It is not hard to find people in China who specify that time horizon at 31 months." written by Don Straszheim, China Analyst for Evercore ISI.
For reference, "31 months" is November 2020. In my opinion, China will do everything in its power to Appease President Trump, while buffeting their own international standing.
The Nuances of Knowing versus Understanding
Coming Next!
Act 3. The End Game
Archive | The Quarterly Update
The Trade War Special Update series was first published on March 2018 and last updated: April 17, 2018