- The U.S.-China "Phase One" trade agreement is mildly positive for global trade, GDP growth, and corporate credit, as it marks a de-escalation of tensions.
- Fundamental issues over trade, technology, intellectual property, and market access haven't been fully addressed, and the bulk of tariffs imposed by both sides remain.
- We expect the next round of negotiations to be drawn out over several years.
The Jan. 15 "Phase One" trade agreement between the U.S. and China is mildly positive for global trade, GDP growth, and credit in that it marks a de-escalation in tensions. The Economic and Trade Agreement between the U.S. and China is, essentially, in two parts: first, the intent by both parties to improve the protection of intellectual property (IP) and market access; second, China's agreement to import more American goods and services.
However, the agreement on IP and market access is open to interpretation, and tariffs imposed on each party's imports from the other remain largely unchanged. Consequently, S&P Global Ratings sees the deal as just the end of the beginning rather than the beginning of the end of the dispute. We expect the next round of negotiations to be drawn out over several years.
Phase One includes, among other things:
- The intent of both countries to improve IP protection, the wider opening of market access for food and agricultural products, improves market access for financial services, and greater exchange rate transparency; as well as
- China's agreeing to import from the U.S. an additional $200 billion (from 2017 levels) in manufactured goods, agricultural goods, energy products, and services (see chart 1).
The agreement itself doesn't mention a cut in tariffs by the U.S., although the accompanying fact sheet on the U.S Trade Representative's website states that the U.S. has "agreed to modify its Section 301 actions in a significant way." This is seen by some market participants to mean that the U.S. will make good on its Dec. 13 announcement that it will defer 15% tariffs on $160 billion of Chinese goods (originally set for Dec. 15) and cut tariffs to 7.5% on $120 billion of imports from China (see chart 2).
U.S. Corporates See Muted Effects Of Phase One
We see the first-order effect on U.S. corporate borrowers to be mostly muted, skewing slightly positive.
The deal will likely improve, for example, American agribusiness companies' grain-trading operations if normal trade flows are restored, given the expected large increase in purchases by China. Nonetheless, these companies will still need to diversify into more value-added ingredients as trading margins face secular pressures--a trend unaffected by any trade deal.
Similarly, the latest step is somewhat positive for U.S. capital goods companies we rate, given that an increase in exports of agricultural products to China could drive demand for farming equipment. However, ag-equipment manufacturers still expect a weak year until there's more clarity on a broader resolution to the trade dispute. And while homebuilders are largely insulated from specific trade factors, the exception is softwood lumber--so they may benefit from some lower input costs and a generally better economic outlook.
In the auto sector, U.S.-imposed tariffs have been a material issue principally for smaller suppliers, some of which import many products from China. In fact, the tariffs contributed to downgrades in at least three cases in the past year. Larger suppliers and auto manufacturers have less exposure, although tariff-related disruption in the supply chain has raised manufacturing costs and slowed production, thus weighing on profit margins.
For U.S. retailers, secular trends outweigh any effect of the trade dispute. Waning consumer optimism and faster-than-expected declines in store traffic have hurt sales, and as consumers make more purchases online, they're more accustomed to waiting for discounts or promotions before buying. This has sparked intense price competition, limiting pricing power and forcing retailers to rely on margin-diluting promotions to lure customers to brick-and-mortar locations. On top of that, the indirect effects from the trade dispute--in particular, caution around investment--are adding to pressures on retailers. On the other hand, toy makers have exposure to China because they manufacture the majority of products there, and so any relief on the tariff front removes a meaningful weight on cost of goods sold in the U.S. And to the extent that levies have (or eventually would have) caused consumers to curb spending, the broader economic benefits of a cooling in tensions could boost discretionary spending.
From an IP standpoint, Phase One will have a somewhat positive effect for U.S. technology firms, removing some business uncertainty, which has hurt global IT spending. Still, we expect U.S. tech firms will gradually increase their non-China manufacturing base as a way to diversify their exposure to the country. This could result in a period of higher spending to build up manufacturing in other regions--which, presumably, have higher labor costs and/or less skilled labor--until scale and operating efficiencies eventually offset costs. (On the flip side, the deal may prove somewhat negative for Chinese tech firms--see below.)
American media companies, too, may benefit somewhat, since poor protection of IP rights in China has been a perennial concern. Stronger legal safeguards could lead to increased investment in China and, thus, higher revenues from that country. Still, the effect on credit would be minimal, as sales in China represent less than 5% of industry revenues.
China Corporates Focus On Business At Home
China's capital goods sector have been fairly unaffected by the trade dispute. For most companies, the lion's share of revenue comes from within China, with other economies in the Asia-Pacific region, Middle East, Africa, and Latin America being major export destinations. Most of their components are sourced locally, and the key components they do import are primarily sourced from Europe and Japan.
Similarly, the effects so far for Chinese homebuilders have been minimal, as both demand and supply depend on domestic factors. That said, if China's economy is severely hurt by trade tensions, domestic demand for properties could slump.
Among auto makers, trade tensions have had a very limited direct effect, given China's auto exports to/imports from the U.S. are minimal. Further, most manufacturers we rate focus on the domestic market and have well-developed supply chains, sourcing most parts locally or from Europe. The few that source from the U.S. have worked to minimize that dependence and have shifted to Europe or domestic sources. The trade dispute has, however, weighed on consumer confidence, which was already weakened by slowing economic growth.
The direct effects of tariffs on the country's auto suppliers also haven't been material, as the sector doesn't have significant sales exposure to the U.S. While tariffs can make for higher procurement cost for their customers, most of these clients are large manufacturers and have successfully applied for tariff exemptions from the U.S.--so most suppliers maintain production in China with some slight reshuffling to manufacturing bases in other regions.
The consumer products sector in China is heavily dependent on the domestic market, with exports accounting for only a small portion of sales. Amid the trade dispute, companies have begun expanding exports to the E.U. and other non-U.S. countries. Still, trade tensions have had an indirect effect on the sector through worsening consumer and market sentiment.
For the Chinese technology sector, the continuing trade dispute, notwithstanding the Phase One deal, may still hurt some large rated borrowers--particularly those on the U.S. government's Entity List (under Supplement No. 4 to part 744 of the Export Administration Regulations) such as Huawei and Hikvision. While the effects have so far been relatively muted, we expect this to be temporary. Currently buoyed by domestic smartphone purchases, Huawei faces significant challenges in overseas markets where its phones will ship without Google services. Similarly, Hikvision could suffer slower overseas sales.
On the other hand, a de-escalation in tension may help the rest of the tech sector, as any suspension of new tariffs on major IT products and reduction in existing tariffs would alleviate demand risk and lower pricing pressures on the hardware supply chain. Either way, many Chinese tech companies are looking to reduce their exposures to U.S. suppliers by investing in upstream technology themselves or by supporting domestic suppliers. The Chinese government is also aggressively upscaling efforts to develop the domestic tech industry through investment and direct support to high-tech corporates.
For The U.S. Economy, Agreement Alleviates Some Secondary Effects
From a macroeconomic perspective, S&P Global Ratings continues to believe the secondary effects of the tariff dispute--and, now, the steps being taken to resolve it--on the economy and borrowers we rate are more material than the near-term direct effects.
In the U.S., consumer spending has remained robust despite trade-related worries and headwinds to goods-producing sectors, which account for 18% of the economy. Low unemployment, rising wages, and strong household balance sheets have bolstered spending--and look set to continue to do so. This is clearly important, given that consumer spending generally accounts for upwards of 70% of the world's biggest economy.
However, second-order effects (which are hard to measure) from the trade war are likely more significant, as deteriorating business confidence curbs spending. And even with Phase One in place, the bulk of tariffs on U.S. imports from China remain. Moreover, nontariff barriers on both sides remain in play, and the next steps in negotiations could prove more difficult, adding to businesses' worries as they plan their investment strategies over next few years. The dispute covers more than just trade in goods, with tech--broadly defined--central to the issue, and any final agreement still seems a long way off.
Through the dispute, American businesses and consumers have borne the financial brunt, while the tariffs have had little effect on China, according to a report from the Federal Reserve Bank of New York (in a National Bureau of Economic Research working paper). The findings supported the authors' earlier research showing that by December 2018, import tariffs were costing American consumers and importers $3.2 billion per month in added taxes, and another $1.4 billion a month in efficiency losses. This helps explain why the U.S. manufacturing sector has fallen into its deepest slump in more than a decade, with the Institute for Supply Management index of factory activity slipping to 47.2 in December—the lowest since June 2009. (A reading below 50 indicates contraction, and last month's figure was the fifth straight below that level.)
Deal Isn't A Game-Changer For China's Economy
Phase One may ease some fears about escalating tensions, but the direct effect on China's economy, which we expect to grow 5.7% this year, is likely to be marginal. S&P Global Ratings estimates that the reduction in tariffs would lift growth by less than 0.1 percentage point compared to our current baseline, due to improving net exports. However, even this small gain would be offset by the appreciation of the trade-weighted Chinese renminbi over the last month. The commitment to scale up purchases of U.S. goods and services may affect the composition of imports but won't likely have a material effect on net trade.
The indirect effects through confidence may be somewhat larger and could spur manufacturing investment, which grew just 2.5% last year--the lowest in at least 15 years. Still, a pronounced upturn in capital spending remains unlikely, especially if uncertainty remains on how non-tariff measures, including export controls, will evolve. Our long-held view is that the economics of the dispute center on technology and not trade, and the effect on China will be felt more in the long term than the short term. The dynamics here are unchanged, and this year may bring more uncertainty on this front.
The effect on China's consumers, too, will probably be negligible. The service sector is now the engine of jobs growth, and moderate changes in manufacturing activity driven by exports to the U.S. would do little to change the employment and wage prospects for the majority of households, at least in the short term. Again, there may be some effect on consumer confidence, but day-to-day spending decisions are more likely to be affected by prosaic concerns, such as food prices, wages, and the property market.
More importantly, the deal will likely do little to alter the way that China manages its economy. One exception would be committing the Chinese government to direct more import spending to American products and services. (Ironically, this may mean more government, not less.) While the deal includes commitments by China to enhance its framework for IP protection, open up the financial services sector, and allow more flexibility in its currency, these were likely to happen in any case--even as the deal may accelerate implementation and introduce enforcement mechanisms. These measures are seen as important for China's development; indeed, Chinese firms are approaching the technological frontier in some industries, and IP protection has become a key concern domestically.
Left untouched by the deal are concerns about market access in many high-growth areas of the economy (for example, IT services), as well as a level playing field with state-owned enterprises and private national champions.
Is Anyone Winning The Trade War?
There are signs that the Trump Administration's tariffs are working, at least with regard to the U.S. trade balance. The country's overall trade deficit narrowed in November by $3.9 billion, or 8.2%, to the lowest level in three years. And the deficit with China declined 15.7%, to $26.4 billion. That put the U.S. trade deficit with China through the first 11 months of last year down 16.2% from the same period in 2018.
However, research published by Panjiva (a division of S&P Global) in December showed that China's purchases of American goods and services fell 21.6% in the past 12 months, compared to 2017, while China's shipments to the U.S. slipped just 2.2%. Moreover, while the U.S. trade-in-goods deficit narrowed 13.3% year-over-year in November, that came with a 4.0% drop in total trade and still left the deficit in the 12 months to Nov. 30 16.6% higher than in 2016. All told, bilateral trade between the two countries tumbled 15.2% in that time.
The chance that negotiations for a final agreement will stall, or enforcement of the Phase One deal doesn't materialize, continue to cast uncertainties over corporate supply-chain strategies. As it stands, most companies haven't altered their supply chains. But there's also the possibility that some have done so too hastily. According to Panjiva, among the most "switched" imports has been wooden furniture, for which seaborne shipments from China to the U.S. fell 14.3% in the 12 months ended Nov. 30, while those from the rest of the world rose 10.1%. U.S. imports of auto parts have trended similarly, with imports of wheels from China down 26.0%, while those from the rest of the world were up by 15.8%.
S&P Global Ratings believes these sorts of uncertainties (and the reactions/over-reactions they spawn) will persist until the countries come to a sweeping, longstanding agreement. This prospect seems unlikely in the near-term, given the complexities involved. In fact, many experts expect the dispute to stretch for many years, since the friction involves factors beyond trade--not the least of which is China's emergence as a global economic power.
- 2020 Outlook: Come for the Commitments, Stay for the Enforcement – Trade War Show Season 4 Begins, published on Panjiva, Jan. 16, 2020
This report does not constitute a rating action.
|Primary Credit Analysts:||David C Tesher, New York (1) 212-438-2618;|
|Terry E Chan, CFA, Melbourne (61) 3-9631-2174;|
|Secondary Contacts:||Beth Ann Bovino, New York (1) 212-438-1652;|
|Shaun Roache, Singapore (65) 6597-6137;|
|Chang Li, Beijing + 86 10 6569 2705;|
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