Over the past three years, U.S.-China (G2) trade tensions, a broader set of competitive issues, and Brexit forced buyers and sellers to re-evaluate the resiliency of their global value chains (GVCs). Despite global growth concerns, policy, not economics, has caused business planners the most angst. We view the so-called “Phase One Agreement” as progress that avoids further escalation of G2 frictions.
NOT ALL POLICY UNCERTAINTY IS RISK
Supply systems devoted to sectors subject to the most tensions remain functional and flexible (technology, agriculture, and consumer goods) despite recent trade tensions. The past three years have introduced GVC uncertainties not seen since the last recession (another disruptive but managed event). Purchasing managers and suppliers will continue to be tested by public policy decisions aimed at trade outcomes. A few examples illuminate our point.
Trade policy strategy for the Trump and Xi administrations will continue to play to a few audiences. While logic prevents both sides from tabling offers intended to resolve major policy disputes, a major breakthrough is unlikely in 2020. Days before the Phase One agreement signing ceremony in DC, three Treasury Department moves demonstrate how developments affecting the broader G2 relationship are likely to influence GVC planning and execution.
The January 13th decision to remove the “currency manipulator” tag from Beijing was a political signal. While a welcome gesture Xi can use to assuage domestic hawks, this was always a side issue. Because the designation isn’t material to core policy disagreements, we don’t expect it to reduce tension over intellectual property discussions.
The pledge to revive and intensify strategic and economic conversations signals China that the U.S. seeks continued dialogue even though differences over Hong Kong and Taiwan governance, south China Sea sovereignty and passage, China’s industrial policies, and technology policy conflicts persist. Treasury doesn’t want tensions to escalate.
Technology competition lies at the heart of President Trump’s National Security Strategy (NSS) signed in December 2017 designating China and others as economic and strategic adversaries. The Phase One agreement punts on that issue and makes the third recent Treasury action – issuing rules updating the Committee on Foreign Investment in the United States (CFIUS) process – the most contentious set of issues underlying the wide-ranging trade tension.
It is apparent that both countries understand the objective of this latest CFIUS revision. The U.S. is concerned that previous voluntary rules and mandated committee review timelines were not always effective in identifying bedrock financing sources in some deals. China sees the U.S. push as an attempt to thwart its entry into dual-use and other leading upstream technologies. On a bipartisan basis, Washington regards the new rules as a necessary national security enhancement.
Although focused first on finance, the CFIUS re-write adds to tech sector competition, which is a growing source of G2 friction. We expect the use of this and other policy tools to make tech, not tariffs, the focus for future discussion. GVCs will be affected but both Huawei and ZTE demonstrate the difficulty each side faces in zero-sum gamesmanship.
Policy makers will continue to struggle with finance innovation’s global spillovers (including digital currency and block chain technologies) but those conversations will occur against a backdrop of dollar dominance. In this way, GVC evolutions will impact U.S. public and private decision makers much more than trade statistics alone convey.
Federal Reserve Board researchers published work late last year examining the effects of U.S. and retaliatory tariffs levied over the past two years (Disentangling the Effects of the 2018-2019 Tariffs on a Globally Connected U.S. Manufacturing Sector – Aaron Flaaen and Justin Pierce).
Their work highlighted effects on global trade and supply chain linkages. The study finds that protectionist measures have not boosted manufacturing employment or output and that tariffs lead to increases in producer prices, which generally are passed onto consumers. The authors conclude that the presence of “globally interconnected supply chains” complicate the promotion of domestic manufacturing. Substitution is not only for products, it’s also relevant to many procurement and delivery systems.
“[O]ur results suggest that the tariffs have not boosted manufacturing employment or output, even as they increased producer prices… In addition, our results suggest that the traditional use of trade policy as a tool for the protection and promotion of domestic manufacturing is complicated by the presence of globally interconnnected supply chains.”
—Flaaen and Pierce, December 23rd
European Central Bank researchers recently published work finding that not only do cross-border spillovers affect trading partners but that density of GVCs adversely multiply those effects (“Rising protectionism and global value chains: quantifying the general equilibrium effects”; Cappariello, Gunnella, Franco- Bedoya and Ottaviano). The more interconnected systems are (think suppliers and buyers of smartphone tech) the quicker and deeper pain is experienced by everyone reliant on a particular GVC.
Policies matter, obviously, but as we ponder what trade in the 2020s will bring – literally and figuratively – the bulk of evidence reinforces the inevitability of GVCs.
…TO THE MAX
Boeing’s 10-month 737 Max production mess is a case study in both disruption and resiliency of GVCs. On January 12th, Woodward Inc. and Hexcel Corp, suppliers to Boeing and Airbus, announced an all-stock deal to combine. The merger is an attempt to adapt to certain risk and an unpredictable outlook. The shares were up 6-10% in January 13th trading.
But that is neither the beginning nor ending of these companies’ ties to policy and the business cycle. Both experienced strong equity value appreciation after two events: the official passing of the Great Recession and period immediately after the Great Globalization encouraged by WTO rules setting. It was the first aerospace industry deal announced since Boeing’s decision to stop MAX production.
Spirit AeroSystems took a different approach. Based in Wichita, the company supplies 70% of the MAX’s structure on January 10th cited “uncertainty related to both the timing for resuming production” and the outlook for near term production levels as the reason for laying off 2800 workers (16% of its employee base). The company’s stock is off 32% this year and 3% in January 13th trading.
POLICY DESERVES DISPROPORTIONATE ATTENTION
Early in the first quarter of a new decade it seems nearly certain that policy (including Brexit outcomes) will displace macroeconomics and sector developments as a risk threat for GVC operators. Supply chains and their larger interconnected systems are subject to every imaginable disruption, including nature and those generated by humans.
Trade policy will likely influence domestic and international politics, U.S. elections, and macroeconomics. Constructive noise about G2 trade tensions easing doesn’t account for President Trump’s decision to maintain tariffs on Chinese goods or the hit those rents impose on U.S. manufacturing performance. Phase One agreements don’t address any of the long-simmering issues Trump cited in the 2017 NSS or his inaugural address such as intellectual property protections, greater access to China’s domestic markets, or the bucket of tech policy disputes.
In our view, the President’s position on tariffs and the lack of a multi-stage negotiation schedule to address national security and economic policy differences create space for trade frictions to fester and possibly intensify. In this context, GVC disruptions in 2020 come more from headline risk rather than tangible risks beyond those already featured prominently in the complicated, uncertain G2 relationship. Buyers and sellers have reasons to stress test their supply relationships and resiliency plans, but neither President Trump nor Xi will find it in their interest to meaningfully destabilize the global economy or Trump’s re-election prospects.
China wants to displace the U.S. as the dominate global force in commerce and technology. The U.S. wants to protect against that outcome. Constructive co-existence remains a possible result of this contest, but the answer won’t be known for years.