Will trade war history repeat itself?

Once upon a time there was an Asian country that had a large trade deficit with the United States. The US said this country manipulated its currency, engaged in unfair trade practices, stole intellectual property and threatened American jobs. The US responded by starting a trade war.

You probably think I’m talking about the current trade war between the US and China but, in fact, the above describes the trade war between the US and Japan in the 1980s.

Interestingly, current United States Trade Representative (USTR) Robert Lighthizer cut his teeth as US President Ronald Reagan’s deputy trade chief in the 1980s. He played a key role in the US-Japan trade talks, just as he is playing a critical role in the negotiations between the US and China.

Some economic historians think that the US “won” the 1980s trade war because Japan agreed to voluntary export restrictions, accepted high tariffs and signed the Plaza Accord. The subsequent appreciation of the Japanese Yen against the US Dollar arguably set in motion a series of macroeconomic conditions that led to the Japanese asset bubble and the Lost Decade(s) that followed when it burst.

As Mark Twain famously said “history doesn’t repeat itself, but it does rhyme.” While there are some similarities between the two trade wars, there are actually many more differences. If Lighthizer and the Trump administration think that they can win the trade war with China by following a similar playbook to the 1980s, they will be very disappointed.

The following outlines and analyses the differences between the two trade wars and highlights lessons from the 1980s that policy makers, and investors, should heed today.

Differences between US-Japan and US-China trade wars

Japan was a democratic ally, China Isn’t 

Following WWII, Japan and the US established a strong post-war alliance which created context for the trade war negotiations between President Reagan and Prime Minister Nakasone. China, however, is a geostrategic threat rather than an ally.

Furthermore, China is not a democracy and in 2018 President Xi removed term limits in China so he can essentially remain President for life. This means China can afford to play the long game. This is very different than the political business cycle faced by Nakasone and Reagan in the 1980s and Trump, who is already looking ahead to the Presidential elections in 2020.

The world wasn’t as globalized in the 1980s

In the 1980s, the world was far less globalized than it is today. As a result, the export restrictions and tariffs imposed on Japan had fewer channels for negative feedback to US companies and American consumers. Today, however, US technology companies are incredibly reliant on the technology supply chain in Asia and China is a huge end market for many US consumer companies.

With respect to the technology supply chain, Ellerston Asia estimates that over 70% of the Bill of Materials (BOM) of an iPhone X are supplied by Asian companies. The majority of these components are manufactured and assembled in China. Other US technology companies such as Dell and HP are similarly dependent on Asia, and China for the production and assembling of their products.

The labour cost arbitrage that still exists between the US and China means that the globalisation of technology supply chains is unlikely to change materially in the near term. Sure, production facilities can shift from China to Vietnam, Cambodia or India, but this will take time (years). So unlike the 1980s, US corporates and consumers are likely to bear the cost of tariffs on technology goods from China.

Similarly with respect to China as a consumption market, American companies like Apple, Nike, Starbucks and P&G generate billions of dollars of sales in China. China as over 1.3 billion consumers versus Japan which had a population of only ~170 million in the 1980s.

These supplier and consumer channels create powerful opportunities for retaliation which was not a factor in the Japan experience.

China will not agree to a Plaza Accord 

The Plaza Accord was signed by five world powers (US, Japan, Germany, France and the UK) in 1985. By 1987 the Japanese Yen had appreciated by over 100% versus the US Dollar. This is not going to happen to the Chinese Yuan (CNY).

The last few days have been very volatile for global FX as CNY broke through the important psychological level of 7 and President Trump officially labelled China a “currency manipulator”. The fact that China only meets two of the US Treasury Department’s four criteria for currency manipulation appears to have been overlooked by the Trump administration. Never let the facts get in the way of a good tweet!

Regardless of labels, it is unclear that the CNY is materially undervalued. A report by the IMF earlier this year concluded that the US Dollar was overvalued by 6-12% while the Euro, Yen and Chinese Yuan were all broadly in line with fundamentals. This is an important point. The US cannot follow a strong dollar policy for decades (it was spearheaded by Robert Rubin in 1995) and then complain about other countries having undervalued currencies. Cross rates, by definition, are relative.

In sum, the Chinese have seen what the strong Yen did to Japan and are not going to agree to anything similar with respect to the Yuan.

Conclusions & positioning

There are two main conclusions from the US-Japan situation that hold lessons for investors today.

Don’t hold your breath

The US-Japan trade war lasted for the better part of a decade. Investors who are hoping for a quick fix in the US-China situation are likely to be disappointed. Even if the current trade issues (agriculture imports, IP, Huawei) are resolved in the next 18 months, the underlying tension between the US and China is a function of American hegemonic decline and the rise of China. This dynamic is not going to go away any time soon.

Beware of unintended consequences 

As described previously, some economists link the US-Japan trade war to Japan’s ongoing macroeconomic issues. When James Baker of the United States and Noboru Takeshita of Japan met at the Plaza Hotel in 1985 they couldn’t have known what economic dominos the Accord was putting in place and how these dominoes would ultimately tip over.

This begs the question, what will be the unintended consequences of this trade war? For example:

Will the anti-China sentiment touted by the US have an impact on the situation in Hong Kong and ultimately the one party-two systems model?

Will Trump’s actions against Huawei (ironically) reinforce China’s efforts to become self-sufficient in semiconductors and other components thereby ending the monopoly of non-Chinese firms in certain areas of the tech supply chain?

What if the trade war reduces global growth to the extent that the Fed and/or the PBOC cuts interest rates to the lower bound? Will this create bubble-like characteristics in US or Chinese assets similar to those in Japan in the 1990s?

What are the longer term economic and political implications of the supply chain moving to countries like Vietnam and Cambodia?

Will the trade war force middle powers like Australia to choose between their geopolitical relationship with the US and their economic relationship with China? If so, what choice will they make?

The US-Japan experience suggests that in the long term, the unintended consequences of a trade war can have as much impact, if not more, than the intended ones.

Positioning

For over a year now, the Ellerston Asia portfolio has been positioned primarily in domestic demand sectors (consumer, financials, internet) and overweight domestic demand countries (India, Indonesia). This positioning has paid off. These sectors and countries continue to thrive despite trade war volatility and offer investors access to high growth, high quality companies that are trading at increasingly attractive valuations. 

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