Market report October 2019
The intricate ties between US and Chinese technology sectors are being tested for tensions in the trade war. Some steps the US has taken against the Chinese giant Huawei Technologies can undo the fire and usher in a new stage in the development of the Chinese technology sector.
The Chinese technology industry was the main focus of US sanctions. As one of China’s greatest successes in corporate innovation, Huawei is a source of pride for China, but the US perceives it as a threat to national security, which uses its technology to collect intelligence in the west on behalf of the Chinese government. The US Treasury Department involved in negotiations with China says, Huawei is a national security issue that is unrelated to trade talks. However, when the US arrested Huawei’s chief financial director in late 2018, many observers felt that technology had become an active front in the escalation of the trade war.
US Crackdown forces Huawei to locate the supply chain
President D.T intensified the repression of Huawei in 2019, effectively blocking the company from the US. The consequences are extensive. Huawei is the world’s largest producer of telecommunications equipment, with revenues of USD 105 billion in 2018, a global market share of around 30% and customers in over 170 countries. It is also the second largest smartphone manufacturer in the world, behind Samsung. In 2018, Huawei invested $ 15 billion in research and development. All this makes Huawei a key player in the global technology supply chain. Until being banned, Huawei relied heavily on US technology suppliers.
During the June G20 meeting in Japan, D.T promised to ease some restrictions on Huawei. Huawei CEO Ren Zhengfei recently said the company is interested in negotiating in good faith to find a solution. Apart from political controversy, we believe that US measures against Huawei and other Chinese technology companies could breathe new life into this sector, forcing Chinese technology companies to strengthen local supply chains.
For Huawei and the global technology supply chain, the immediate impact of sanctions was visible. The company is a key consumer of technologically advanced products and services. Indeed, after losing access to Google’s Android operating systems, Huawei said it expected a sharp decline in smartphone sales. Because Huawei is a major producer of 5G network devices, restrictions can also slow down global progress in upgrading networks to 5G.
Over time, however, Chinese companies will accelerate their efforts to develop greater self-sufficiency. Even if the US ban is eased or lifted, we expect last year’s events to strengthen Chinese technology companies and authorities to reduce their dependence on suppliers abroad.
It will not happen overnight. There are still large gaps in several areas of China’s technological ecosystem that will take some time to fill. Local Chinese suppliers will also need to continue raising production quality to include them in Huawei products. Over time, increased demand will encourage Chinese suppliers to intensify their activities. Our research suggests that Huawei works closely with local suppliers of printed circuit board (PCB) materials and optical components to reduce the technology gap. Technology groups from South Korea and Taiwan can also take advantage of Huawei’s search for new suppliers.
In China, selected defense technology companies deserve more attention. These include companies with manageable exposure to Huawei, which are relatively isolated from commercial tensions in China, with good growth prospects and high quality products. For example, some Chinese companies could benefit from the final global implementation of 5G telecommunication networks, because the technology gap in relation to American competitors is not, in our opinion, too large.
A good example is Shengyi technology. The company is the largest Chinese supplier of copper clad laminate (CCL), a key material for printed circuit boards. We believe that the demand for high-quality CCL materials will increase, as networks eventually switch to 5G technology, with much faster data transmission and much lower delays than 4G. Indeed, Huawei is already working with Shengyi, and his relationship with the current American supplier has been broken.
Chinese suppliers of optical components are also entering the void resulting from the US ban. These include Accelink Technologies and Zhongji Innolight. Both companies have technology that has allowed them to move away from dominant US suppliers who have been pushed out of the Chinese market.
The ongoing trade war continues to cause market volatility and overrides the prospects of the Chinese economy. However, we believe that these are excellent conditions for investors to look for development opportunities. Long-term capital investors may find surprising trends that can transform the little-known Chinese technology companies into major industry players – with high return potential.
The so-called “mini-agreement” between the US and China does not change the global economy. The average tariff in the US can reach around 8.5% by the end of the year (considering the 10% tariff for importing cars from the EU). Policy instability is a new standard in trade negotiations and goes beyond tariffs (prohibitions lists).
A comprehensive contract is far away. The parties are facing the hardest part of the negotiations: both are becoming so-called the “second phase”, which in particular should concern market access, intellectual property protection, Chinese industrial subsidies, US sanctions against Huawei and Chinese companies. Before the US elections in 2020, the chances of a comprehensive agreement are rather small.
We estimate a 55% probability of a scenario in which the US will focus its trade policy on Europe. For a 10% car import tariff, total EU export losses would be EUR 4 billion per year, and GDP growth would be adjusted by an annual amount of -0.1 percentage point.
On October 11, the White House announced a “deal” with China, although officially the Chinese press did not use the words “deal” or “agreement.” Details will be finalized within the next month when Presidents D.T and Xi sign an agreement in Chile in mid-November at the APEC summit. However, this agreement is the “first phase” of the negotiations. During the White House meeting with Liu He, China’s deputy prime minister, President D.T said: “… it’s a great thing that doing it in sections, in phases, is really better. That is why I anticipate two stages or three stages of negotiations.”
What is said that both sides agreed (arrangements details may change in the next four weeks):
Suspension of the increase from 25% to 30% of tariffs on USD 250 billion of Chinese imports planned initially for October 15. However, tariffs from December 15 are still in preparation, which means that they may depend on negotiations in the second phase.
- USD 40-50 billion in annual US agricultural purchases and changes in agricultural policy;
- Currency transparency (renminbi management guidelines);
- Opening market access for US companies providing financial services.
Bilateral trade between the US and China, y / y:
Source: National Sources
|Tranche||Value||Current tariff||Product groups||Changes after 15/10/2019||Potential changes in the future|
|1+2+3||About 250 bln USD||25% (July 6, 2018, August 23, 2018, May 10, 2019 respectively)||Industrial machines, capital goods, electrical equipment, furniture, electronics, cars, leather products||No tariff increase up to 30%|
|4A||About 300 bln USD (4A + 4B)||15% from September 15, 2019||Clothing, footwear, electronics, TV sets, monitor screens||Can be raised to 25%|
|4B||15% from December 15, 2019||Cell phones, toys, computers, electronics.||It may be delayed in time; can be raised to 25%.|
Source: National Sources, RCieSolution research
Tariff volatility will remain, in particular in the face of an impeachment investigation. Although the mini-deal has eased the financial markets, it will not improve global economic growth, which will continue to slow down to + 2.2% in 2020, the lowest level since 2009. We believe that the US impeachment investigation will cause further noise and will direct President DT’s attention to other regions (similar to the recent conflict with Turkey). The US economy will probably continue to slow down before the negative growth quarter in 2020 Q1. The Fed should continue the monetary easing cycle: we expect another rate cut by the end of the year and two, maybe three more in 2020. As a reminder, as part of monitoring the transition to a full-fledged “trade war” takes place at a 12% average US tariff threshold.
To transition to a full-fledged trade war, you need two of the following three events:
- Mexican tariffs increased to 25% on all imports (USD 370 bln);
- 25% of the tariff for all cars imported into the USA (USD 200 bln);
- Tariff increase from 15% to 25% on list 4 (A and B) of US imports from China (USD 300 bln).
We expect a correction in European stock markets, which will reassure the ECB in lowering the deposit rate in QI 2020 and increasing the QE volume (from the current EUR 20 bln per month to EUR 30 bln).
The FED lowered the reference interest rate by 25 basis points at each of the last two meetings. Most analysts expect one additional cut in interest rates by 25 basis points over the next few months. It is likely that the FED will lower interest rates more than the market expects. We believe that the global slowdown and cumulative effects of the trade war mean that the economy is likely to slow down more than market consensus predicts. The FED will react by lowering interest rates more than expected by the market. We believe that this will be effective enough to prevent a deep recession in the economy. But we have to admit, the risk is huge, the situation is dynamic and should be constantly monitored. If the economy deteriorates more than we expect, it is highly likely that the FED will have to lower the reference interest rate to zero.
We believe that tools are available and there is reason to be optimistic that these tools can be effective. The guidelines in which the FED undertook not to raise interest rates for a certain period of time, until certain macroeconomic indicators are achieved, are something that the FED has used effectively during the recent crisis.
The FED will return to quantitative easing, as it did during the last crisis. It appears that the quantitative easing in which the FED extends its balance sheet appears to be effective without causing significant risk to economic prospects. This is something they feel comfortable with. And although it was previously an unconventional policy, it is something that we now consider to be conventional policy, although relatively expensive. During the last meeting and voting in favor of lowering interest rates by 25 basis points, two members of the FED committee voted for lowering tchem and one member voted for their reduction by 50 basis points.
I think it is good to know both points of view represented by committee members.
Intervention of Turkish troops in Syria
Following the recent intervention of the Turkish army in northern Syria, the US administration announced sanctions against Turkey, by increasing the tariffs for steel imports from Turkey from 25% to 50% and banning the financial accounts of the three most important US officials. The direct impact of this measure should remain insignificant because the United States is a small export target for the Turkish economy.
Indirect effects, such as the evolution of the TRY course, rolling debts and making payments, would have wider consequences.
Turkey’s economy is not immune to a new shock. In the face of a deep recession that occurred in the second half of the year, caused by a significant exchange rate shock (-50% exchange rate depreciation, with the lowest level recorded in August 2018) and low GDP growth (0.2%) Materializing European sanctions would be a real breakthrough, as Turkey’s major foreign exposures concern Europe (trade, finance). However, Europe’s exposure to the Turkish economy is significant, making severe financial sanctions unlikely.
Turkey’s exposure to international trade
Source: National Statistics.
On the left, the main export markets, broken down by country and % share, on the right, the main import markets.
Turkey experienced a severe recession in the second half of 2018 (seasonally adjusted GDP was -4.1% in Q4), the economy reached its lowest level after a significant correction in demand (imports fell by -20% y / y on average over the last 12 months). This was conducive to stabilizing the economy, and the central bank eased its monetary policy by -325 bp in September 2019.
Among emerging markets, the Turkish economy still seems to be the most exposed to external shock, due to strong financial needs. The dovish attitude of the central bank devalued TRY (-5% in October to a six-month minimum), with the additional risk of a 25% depreciation in the scenario in which significant European sanctions would be imposed.
The increase in corporate debt and the recession have led to corporate insolvency. Deterioration of payment terms vs cash needs DSO (Days Sales Outstanding) increased by +11 days from 2008 68 trading days to 79 days in 2018. In the banking sector non-performing loans (without reserves) increased from 3% to 6% of capital in over the past year. At the same time, we expect corporate insolvency to increase by + 8% in 2019 and reach + 20% above the lowest level in 2016.
Stress episodes on the US money market
After several episodes of stress observed on the US money market, the FED decided to introduce liquidity into the banking system and resume purchases at the Treasury Security Department. We have identified three factors that explain the mismatch of money supply and demand:
- Technical factors such as liquidity demand for tax collection or regulatory aspects. They are not a completely convincing explanation for us.
- Higher debt issuance by the US Treasury Department, despite the process being coordinated with banks.
- Margin call, ie cash flows related to the functioning of derivative markets.
The current situation should be monitored in a special way due to:
- wholesale financing, which in the past supported risky activities and contributed to the subprime market crisis, has not completely disappeared;
- new stress episodes on the US money market may have repercussions on the credit market that is close to the bubble;
- smaller banking institutions may face difficulties, due to more difficult access to liquidity financing, which means that small and medium-sized enterprises (SMEs are mainly financed by smaller banks) may in turn be exposed to tightening credit conditions and thus higher risk;
- any failure in the US money market has the potential to cause liquidity shortages at a global level, with serious consequences for emerging economies;
- with greater access to cash, high leverage investors may face funding difficulties, such as margin calls, and may therefore be encouraged to launch rapid sales with strong and negative impacts on the markets.
Highest overnight repo rate and issues of government bills and coupons.
Source: Bloomberg, USRG1T ICUS Curncy.
The FED, might look like, underestimated the system’s demand for reserves – the money of the central bank, which banks use to settle their own transactions as well as transactions initiated by clients. The repo market is essentially an interbank market through which banks borrow or draw reserves to manage their cash positions.
The reserve has two forms: the un-borrowed reserves that the FED issues when it buys securities on the open market (QE), and the borrowed reserves that the FED lends on the overnight market to secure repurchase or repo contracts. Data on reserves are published every two weeks, the reporting period ends on Wednesdays. As at September 11, 2019, un-borrowed reserves amounted to USD 1,462 billion, and borrowed reserves were only USD 114 million. Borrowed reserves are a system security valve. They are used in a so-called marginal fine-tuning operations.
The increase in borrowed reserves by USD 180 billion is not normal, we do not know why there was such a sharp increase in demand for reserves. In the FED report, positions “other” increased by $ 18.5 billion from the weekly average. This position began to grow in April and May this year. At the end of the reporting period, August 14, increased to the highest level of USD 93 billion. The “other” category includes “designated financial market tools” (The Clearing House Payments Company LLC, CLS Bank International, Chicago Mercantile Exchange Inc., The Depository Trust Company, Fixed Income Clearing Corporation, ICE Clear Credit LLC, National Securities Clearing Corporation, The Options Clearing Corporation), i.e. clearing houses that form the basis for the functioning of the derivatives market.
Perhaps the explanation for the situation is that margin calls, which are inherently unpredictable, have caused tensions in the repo market. In the past, the increase in the “other” position in Q1 and Q4 2018 was also associated with increased volatility in the money market.
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The views expressed in this document do not constitute research, are not investment or commercial advice and do not necessarily reflect the views of all management teams. They change over time.