Managing The Dragon’s 2019 Predictions

“If you are going to be a bear, be a grizzly,” my father used to tell me. That’s the way I feel about going into 2019 with my five predictions for the New Year. Four of the five are dependent to a greater or lesser degree on the trade war between the United States and China being history by mid-year. If that happens, those four predictions will most likely hold up. If not, it will be a tough year.

For better or for worse, here goes.

Prediction #1: The trade war between the United States and China will be successfully resolved. While all of the issues between the two countries may not be resolved by March 1, the deadline for the truce will be extended as needed. By June 30, the trade war will be history.

Prediction #1 is not based on wishful thinking, but what I believe to be a realistic assessment of the facts.

The first is that the tempo of discussions between China and the United States suggest that the conflict is on its way to successful resolution. Tensions in the trade conflict peaked last September 24 when President Trump announced tariffs on an additional $200 billion of goods from China, saying that he was prepared to impose tariffs on all $500 billion of goods from the country. No meaningful discussions were held until the Buenos Aires dinner on December 1 that produced the current truce. In my more than 25 years in China, I have learned that no progress can be made unless both sides are talking. At this point, both sides are definitely talking.

The second is that there has been positive movement since the dinner. As part of the truce, the United States agreed not to increase tariffs on $200 billion of goods to 25 percent for at least 90 days. Meanwhile, China has already taken a number of positive steps. For example, China has agreed to label fentanyl a controlled substance and has reduced tariffs on cars built in the United States from 40 to 15 percent. In addition, China has resumed soybean purchases from the United States and has announced plans to give foreign companies greater access to its economy and to draft a replacement for its contentious “Made In China 2025” policy. Just before Christmas, a new draft law on foreign investment was submitted to the National People’s Congress that proposes a ban on forced technology transfer and illegal government “interference” in foreign business operations.

Earlier this month, North Korean leader Kim Jong Un happened to show up in Beijing while the U.S. trade delegation was in town. Following the meeting, President Xi Jinping said that: China “encourages North Korea to continue in the direction of denuclearizing the (Korean) peninsula” and “supports a summit between North Korea and the U.S. to achieve results.” While discussions with Kim are separate from trade negotiations, China’s support for talks between the United States and North Korea are an important element in the overall Sino-American relationship.

Finally, both the United States and China are at a point where a successful resolution of the trade war will provide a significant boost to each country’s economy and stock market. At the time of the Buenos Aires dinner, China’s stock market was off by almost 21 percent since the onset of the conflict, and the renminbi was almost 9.0 percent lower against the dollar. Meanwhile, the U.S. stock market was up by almost 7.0 percent, and the dollar was stronger against the renminbi

At that point, the impact of the trade war had not yet begun impacting the real economies. China’s exports to the United States were up by 8.0 percent through October, the latest month for which data is available, and China’s overall export growth accelerated from 9.8 percent in August to 14.5 percent in September, with analysts predicting that China’s exports would expand by 8.7 percent for all of 2018.

Impacted by signs of a slowing Chinese economy and the overhang of the trade war, China’s stock market sold off further in December, recording its worst performance in 10 years. Similarly, the threat of higher interest rates; a political stalemate over money for a border wall; concerns about a slowing Chinese economy; and the impact of the trade war on the Chinese and global economies led to a sharp selloff in the U.S. stock market in the final month of the year.

The two countries are now at a point where a successful resolution of the trade war would have a very positive impact on investor sentiment and the economies of both. The United States and China are now aligned, and both sides have a strong incentive to resolve the conflict

Prediction #2: China’s stock market will regain at least one-half of the ground it lost in 2018.

Over the past 10 years, I have on several occasions included a prediction about China’s stock market as one of my five, and every time I have succumbed to the temptation to do so, my prediction was either partially or totally wrong. Despite my resolution to never again make a stock market prediction, I am compelled to include one for 2019.

At the beginning of 2018, the Shanghai Stock Exchange Composite Index (“SSE”) was 3,392. By the end of the year, the SSE was 2,494, off 26.5 percent on the year and at its lowest level since November 2014. However, there are several reasons to believe that China’s stock market hit bottom last year.

Putting the trade war aside, which has had a definite, negative impact on investor sentiment, the government’s continuing deleveraging efforts adversely affected the Chinese economy last year. From 2012 to 2017, China’s overall debt to its Gross Domestic Product (“GDP”) increased from 200 percent to 300 percent, with corporate debt accounting for just more than one-half of total borrowings. At a three-day, closed-door meeting in Beijing at the end of 2017, China’s leadership made reducing financial risk an economic priority for the next three years. As a result of China’s resolve to reduce borrowings, credit has been tight; the country’s state-owned enterprises are being pressured to repay loans; many online lending platforms have collapsed, hurting consumer purchasing power; and margin debt on Chinese stock exchanges are at a low point and one-third of where they were in 2015.

With much of the negative news about China’s economy already baked into stock prices, the recent actions taken by China to stimulate its slowing economy and a successful resolution of the Trade War should provide impetus for a better stock market performance in 2019. While a 32 percent rise to recover all of the ground lost in 2018 may be too much to expect, a 449 point, or 18 percent, rise to 2,943 seems reasonable.

Prediction #3: U.S. exports to China will set new records and increase by 15 to 30 percent in 2019, depending on the date when the trade war finally ends.

Is China willing to help narrow the trade deficit with the United States in a meaningful way, and if so, does it have the ability to do so? The evidence suggest that the answers to both questions are “yes.”

Since 2015, U.S. exports to China have ranged from $115 billion to $130 billion. Based on exports through October, the latest month for which data is available, U.S. exports to China were somewhere around $122 billion in 2018. A 15 to 30 percent increase would add at least $18 billion, and as much as $36 billion to U.S. export sales, either of which would be an all-time record.

In 2017, China imported $1.8 trillion worth of goods from around the globe, including $129.9 billion from the United States. China was the third largest export destination for U.S. goods, and the leading export categories included agricultural products, aircraft, machinery, vehicles and electrical machinery. Our analysis of the data identified at least 30 product categories where the United States ranks among the top five global exporters, and where China ranks among the top five global importers. These 30 product categories alone account for over $500 billion of China’s imports. If Chinese companies were to switch just 10 percent of their annual imports of these products to U.S. suppliers, that would create additional exports of over $50 billion for U.S. companies.

Of all of the issues between the United States and China, the most quantifiable is the trade deficit. Voters in the United States will know very quickly whether the trade negotiations have produced tangible results by the export data, and China understands this dynamic. In an effort to short circuit the imposition of tariffs, Chinese negotiators proposed last June a package of U.S. farm and energy products, including soybeans, corn, natural gas, crude oil and coal, which China would buy and which officials from both sides valued at nearly $70 billion in the first year.

In December, Unipec, the trading arm of Sinopec, a state-owned, major oil company and China’s largest buyer of U.S. crude oil, reported that it is set to resume purchases from the United States very soon, and volumes are likely to be significant. As evidenced by Unipec’s announcement, China’s large state-owned enterprise (“SOE”) sector gives the country the ability to influence purchasing decisions to promote the interest of the country as a whole. In 2017, the assets of China’s SOEs totaled 72 trillion yuan ($10.5 trillion).

Prediction #4: The renminbi, China’s currency, will trade in a range of from 6.5 to 7.0 to the US dollar in 2019.

The exchange rate between the renminbi, or yuan, has been a bit of a roller coaster over the past several years. Heavy outflows of capital caused the yuan to weaken from 6.05 to the US dollar in January 2014 to 6.95 by January 2017. To counteract this outflow, China spent more than $1 trillion of foreign currency reserves to prop up the yuan, and in 2017, the government began restricting overseas acquisitions by Chinese companies. As a result, the yuan strengthened against the US dollar in 2017, reaching its high point of 6.34 to 1.0 in March.

With the onset of the trade war, the yuan weakened to nearly 7.0 to 1 at the low point of negotiations. With the declaration of the truce, the yuan has strengthened to its current level of 6.75, suggesting that a successful resolution of the conflict will have a positive impact on investor sentiment and the currency.

Even with a successful resolution of the trade war, it is difficult to see the yuan strengthen beyond 6.5 to 1 in 2019, though. Recent actions by the U.S. Federal Reserve System and higher interest rates in the United States have increased the attractiveness of dollar based assets. On the other hand, China seems to have drawn a line at 7.0 to 1 and is unlikely to allow the yuan to depreciate beyond that level.

Prediction #5: New Energy Vehicle (“NEV”) sales will reach 2.0 million units in 2019, widening China’s lead in the global electric vehicle industry.

In 2018, China’s sales of NEVs, which include battery electric vehicles, plug-in hybrids (“PHEVs”) and fuel-cell cars, nearly doubled to 1.2 million units, making China once again the clear leader in the global electric vehicle industry. Sales of NEVs in the United States also had an impressive increase of 81 percent to 361,000 units, but the U.S. market still trails China by a wide margin. Fueled by stronger expected sales of PHEVs, which grew by 140 percent last year, and the implementation of new Corporate Average Fuel Consumption (“CAFC”) standards, sales of NEVs in China will set another record and reach 2.0 million units in 2019.
Growth of China’s NEV industry has been driven by a robust consumer subsidy program, which has provided cash subsidies to consumers of up to $10,000 per electric vehicle purchased. Because PHEVs have not been eligible for subsidies, hybrids have not been as popular with Chinese consumers.

In 2017, however, China announced its intention to phase out its subsidy program by 2021, replacing it with new CAFC targets and a combination of credits and dis-incentives designed to promote the deployment of NEVs in China. The new rules require automakers to produce fleets with a CAFC of 42 miles per gallon by 2020, and 54.5 miles per gallon by 2025. Beginning in 2019, automakers must earn points equivalent to 10 percent of the vehicles they produce in China and import into the country, rising to 12 percent in 2020. Under the new system, automakers earn super credits for the production of NEVs and energy saving vehicles. For example, passenger car models with a pure electric range of 50 kilometers are counted five times, and models with a combined fuel consumption lower than 2.8 liters per 100 kilometers are counted three times.

China’s new NEV policy will require all assemblers operating in China to produce and sell more NEVs, thereby shifting the burden of growing NEV sales from the government to the assemblers. The penalty for not being in compliance could be as drastic as the regulators suspending production of a company’s high-fuel-consumption models. Because hybrids improve an assembler’s CAFC and will no longer be disadvantaged in terms of subsidies, sales of hybrids can be expected to show particularly strong growth this year.

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