The ongoing battle between the United States and China for economic supremacy isn’t only being fought in the gilded ballrooms of Washington, as trade negotiators from either side parry over automobile parts content, intellectual property rights, government subsidies and the like.
Casualties and victories are also borne out over the decks of hulking freighters that carry the commodities which make up the nuts and bolts of international trade.
Indeed, shipping statistics are often sought by economics and traders trying to predict the health of a country’s economy or the world economy. The Baltic Dry Index (BDI) is one such leading indicator. Another is the Purchasing Managers’ Index (PMI). PMIs are a monthly survey of supply chain managers across 19 industries. An economy with a PMI of over 50 is considered to be growing; under 50 means an economy is treading water or possibly drowning.
This article is concerned with the Baltic Dry Index and other shipping statistics - such as cargo volumes through West Coast ports - that we can use to determine who, at this stage, China or the US, is winning the trade war.
The overall conclusion we, at Ahead of the Herd, came up with, is that the United States is winning, in terms of raw economic data, but at a cost to both economies of roughly $165 billion in two-way trade. The losers also include US consumers who are paying more for imported goods, and companies in both countries that can’t afford 25% tariffs for an extended period of time.
Baltic Dry Index
Created by the London-based Baltic Exchange, the Baltic Dry Index is a measure of supply and demand for bulk cargo such as iron ore, lumber, coal, grain, etc. Demand for such bulk-shipped (as opposed to containerized cargo) raw materials is a predictor of future economic growth. For example, a country that is expanding its steel output will order more iron ore and coal, which will increase the demand for shipping these commodities. Therefore, an expanding or contracting BDI is considered to be a leading indicator of industrial production and economic activity.
The BDI is calculated by assessing multiple shipping rates across 20+ routes for each vessel category - Capesize vessels weighing over 100,000 dead weight tonnes (DWT) (these ships cannot go through the Panama Canal); Panamax ships 60,000-80,000 DWT that can go through the Panama Canal; and Supramaxes or Handymaxes, similar in size to a Panamax but with specialized loading/ discharging equipment. Members of the Baltic Exchange contact dry bulk shippers worldwide in order to gather the prices of each raw material included in the index, then calculate an average price for each. The BDI is issued daily.
Those that follow the Baltic Dry Index diligently can glean precious information in which to make investment decisions that few investors are aware of. For example, the BDI is known to have predicted the 2008 recession when the prices of key commodities in the index suddenly dropped.
The BDI has also been shown to correlate with stock market indices. The movement of the Baltic Dry Index usually shows up around 25 trading days later in the machinations of the S&P 500, which is pretty useful as it can help determine when to buy or sell equities.
A recent article in 321gold shows a graph whereby the BDI and the S&P 500 are closely correlated, except for January and February 2019 when the lines diverge ie. a significant drop in the BDI didn’t show up in the S&P. But the outlier event, explained the author, was likely the collapse of a tailings dam in Brazil which suddenly meant a large decrease in the shipping of ore from Vale’s Minas Gerais mine.
Right now the BDI is moving higher, which could signal a leg up in the S&P 500, if the correlation holds.
We can also use the BDI to analyze the trade war. The index rose to a 2018 high last September, but it dropped sharply, over 50%, in the first two months of the year (to the lowest in two years) due to declining demand for commodities particularly China, the world’s largest commodities consumer.
Why would that be? Well, there are two factors at play. The first is slowed shipments between China and the US, in 2019, as tariffs first introduced in July of 2018 started kicking in. Many shippers throughout 2018 tried shipping as much product as they could before an increase in tariff rates from 10% to 25%. More about that below.
The second as mentioned is Vale’s iron ore tailings disaster. The two factors account for the decline in the BDI for January and February.
An article in Seeking Alpha said February was likely the bottom for shipping rates, with some Capesize vessels being chartered for under the break-even rate of $15,000 a day, or more. Indeed the BDI has risen since then, and is currently sitting at just over 1,000. Note the five-year BDI hit an all-time low in the beginning of 2016, which correlates to the bottom of the 2012-16 mining bear market.
Weak global growth
Now that we understand what the BDI is and how it can be used as an analytical tool, we turn to the state of the global economy. Investors are not only worried about the effects of the trade war on global trade, they are also concerned it is weighing on global economic growth. What is the state of the world economy? What can shipping statistics tell us about where the economy is heading?
Nearly a year into the trade war between China and the US, observers are starting to see it in more “geopolitical” terms. No longer is this about tariffs on steel and soybeans, it’s morphed into a fight over technology (ie. the conflict with Huawei and ZTE), rare earths are being introduced as possible pawns, and it can even be framed as the battle for global supremacy between the planet’s leading economic and military contenders, the United States and China.
Witness the constant tensions in the South China Sea, China’s unsuccessful role in containing North Korea, and its controversial Belt and Road Initiative which seeks to create a China-centric trading block in southern Asia to counter US influence.
The trade war is spilling over into other areas, too. Equity markets are in turmoil, stocks of US multinationals have declined, and the price of oil ended its worst week of the year last Friday. US and Chinese consumers are having to pay more for imports, which is likely to shrink consumption and weigh on each’s GDP.
According to the Federal Reserve Bank of New York, the latest round of tariffs will cost the average American household $831 this year.
In short, it’s not looking good. Bank of America-Merrill Lynch recently warned that “increased tensions may impact markets severely,” in a note to clients, stating, rather ominously, “The most important point to grasp is whether the trade war is just about trade, or instead we are just witnessing the early innings of the most important geopolitical conflict of our time,” as quoted in Yahoo Finance.
CNN paints an equally foreboding picture, noting in an article on Sunday that Treasury yields are down and that global economic data has disappointed, which could easily lead to another stock market downturn once the rot sets in:
Escalating tensions between the United States and China clearly pose a problem. Businesses are saying that new rounds of tit-for-tat tariffs will hit their bottom lines, while economists warn of global ripple effects. The situation is made worse by the fact that there's no end to the fight in sight.
Goldman Sachs analysts said last week that if the United States moves forward with threatened tariffs on all remaining imports from China, it would push the US stock market down an additional 4%. Markets have already been rattled by trade fears: The Dow just declined for the fifth straight week — its longest weekly losing streak in nearly eight years.
But it's not just about whether markets wake up to the fact that they'd priced in a trade deal that was far from certain. Apprehension over trade is now magnifying other signs of weakness, resurfacing concerns about slowing global growth that dominated markets in December.
Recent economic data has revealed key soft spots. Manufacturing in Europe and China appears weak. Germany's economy appears to have slowed this quarter "to little more than a crawl," according to research firm Capital Economics, which pointed to manufacturing and business climate figures.
The chances of Britain crashing out of the European Union without a deal have also increased.
Meanwhile, the yield on the benchmark 10-year US Treasury fell to its lowest level last Thursday since late 2017. Bond yields tend to fall when investors are worried about sluggish growth.
Then there's US oil, which fell nearly 7% last week to $58.63 a barrel. It was the worst week in five months.
But there’s more. Orders for durable goods are down and the PMIs of the countries that count are, frankly, sucking wind; Wolf Street called the US PMI figure, “the cleanest of the dirty shirts.”
The finance publication notes that orders for durable goods like cars and appliances have steadily ticked down since December and have shown no growth for three months in a row. The PMIs for US services and manufacturing in May were the lowest since recessionary 2009.
After the data was released GDP forecasts for the second quarter were slashed from 2.2 to 2% in the best case scenario (Barclays Plc) to 2.25% to 1% in the worst case (JPMorgan Chase).
Across the pond in Europe, Germany’s PMIs have been awful, according to a survey. At least the US is above 50. The PMI of Europe’s strongest economy slumped to the mid-40s, the lowest since July 2012 near the bottom of the euro debt crisis said Wolf Street, placing trade war concerns at the heart of the problem:
The manufacturing sector has been weak since February, but the PMI survey suggests that “the sector’s woes intensified in May to mean factories will therefore likely act as an increasing drag on the economy in the second quarter.”
“Trade wars remained top of the list of concerns among manufacturers, alongside signs of slower sales and weaker economic growth both at home and in key export markets,” the survey said.
Meanwhile China’s PMI - the one everybody watches - also slipped further under the 50 threshold, from 49.5 in January to 49.2 in February. CNBC however sounds a glimmer of hope, noting that China’s steel imports for the first two months were pretty close to last year’s same period:
This suggests fairly steady demand, and fits with a picture of a Chinese economy that has lost some momentum but isn’t yet at risk of a serious slowdown.
Tabulating the trade war score
Of course, what we all really want to know is, who’s winning the trade war? On May 6 Reuters asked that question and came up with some valuable insights. We decided to compare their data to our shipment data to see if they match. By and large, they do.
For those having trouble keeping track of all these tariffs, a recap:
- The trade war kicked off last July with $34 billion of tariffs on Chinese imports. This was followed by $16 billion worth last August and another $200 billion in September. China matched US duties with its own tariffs on American goods.
- The Trump administration threatened to up the tariffs on the September list of products from 10% to 25%, but that was suspended pending trade talks. The collapse of those talks earlier this month means the 25% rate kicks in June 1.
- The latest development is that a further $325 billion in Chinese imports is being put into motion, the result of which is that all Chinese imports will become subject to tariffs.
As for the trade war’s impact, these are the key takeaways, according to Reuters:
- In the first quarter of 2019, Chinese imports tanked by a third compared to last year’s Q1, and exports fell by a tenth.
- The sector of Chinese exports that has been worst hit, is machinery and electrical equipment.
- The trade war has knocked between 0.1 and 0.2% off US GDP; but for China, it could mean a loss of 0.3 to 0.6% of GDP. That doesn’t seem like a big difference, but in GDP terms, it is.
- In the first quarter, the Chinese economy grew by 6.4% compared to 6.7% in the second quarter of last year - the last quarter before tariffs were imposed. For the US the equivalent figures are 3.2% versus 2.9%.
- The flow of US imports is being re-routed, in other words, goods that would normally come from China are coming from elsewhere - like Vietnam, South Korea and Mexico.
- The Centre for Economic Policy, a think-tank, estimates $165 billion in trade has been lost or redirected to avoid tariffs.
Oceangoing freight volumes down from record highs
We can utilize shipping statistics to trace the pattern of imports and exports that we see imprinted by the trade war.
First, it’s interesting to note that 2018 was a record year for shipments of commodities hit by tariffs. The reason is retailers stocking up on goods they knew would get hammered with a 15% increase (10% to 25%) if trade talks failed. This is called “front-loading”, and it shows up in port statistics.
California’s three major ports - Los Angeles, Long Beach and Oakland - handle about half of the United States’ containerized cargo. 2018 saw a notable trend of more imports coming from China, due to front-loading, and a drop-off in US exports to China. Chinese imports to all three ports increased from 5.4 million containers in 2017 to 5.7 million in 2018. Exports to China, on the other hand, dropped from 881,128 containers to 701,493 containers, year on year.
The CEO of Maersk, the world’s largest containerized shipping company, remarked that Chinese exports to the US grew 5-10% in the third quarter of 2018, versus a 25-30% fall in US exports to China.
A record $539.5 billion in Chinese goods were imported by the US in 2018, but only $120.3 billion worth of American products were shipped.
Fast-forward to the present situation, which looks quite a bit different. Seaborne imports into all three California gateways from China have slipped considerably. Wall Street Journal reported container imports into Los Angeles and Long Beach declined a combined 10.2% compared to February 2017. The Port of Oakland saw a 5% drop in volumes.
Trading data evidence shows the United States is substituting Chinese-made products from those manufactured elsewhere. According to S&P Global Market Intelligence, Chinese furniture imports fell 13.5% in the first quarter versus a 37.2% increase in imports from Vietnam and a 19.3% hike from Taiwan. Refrigerator imports from China dropped 24.1%, but South Korea and Mexico each exported 32% more fridges to the US. Tire imports from China were down 28.6%, replaced by Vietnam's which more than doubled to 141.7%.
US-China trade deficit at 5-year low
Currently the United States is exporting more to China, despite tariffs, while importing less from China. The result, as President Donald Trump hoped, is a lessening of the US trade deficit with China. In fact the deficit is at a five-year low.
In particular, the Chinese are importing more coking coal from the States - five times as much in April compared to March, even though there are 25% tariffs on US thermal coal and coking coal. China has also resumed buying US soybeans.
Not so fast
I started this article by asking a simple question: Who is winning the trade war? I wanted to take a bit of a different tack, by answering the question with shipping data. Actual shipments are something tangible, and therefore have more value, in my opinion, than GDP data, a PMI, or imports and exports. Shipping stats also give us, as investors, something to watch for. They are important indicators of future economic activity, and are therefore ignored at our peril. Remember, those who paid attention to the Baltic Dry Index could have avoided the Great Recession.
The US is in fact winning the trade war. We see it in the slowed imports of Chinese goods, and increased exports of US goods, with the resultant narrowing of the US-China trade deficit. Shipments from China went bonkers last year, as US retailers stocked up before getting whacked by 25% tariffs. Now, those same companies are shunning China, and cozying up to South Korea, Vietnam and Mexico. Chinese goods are being replaced.
That was the whole idea, but is this not a pyrrhic victory? Consider that in order to gain the upper hand over the Chinese, the Trump administration has forced a reduction of $165 billion in two-way trade. Global growth is weak, the US PMI is barely holding above 50 (ie. the US economy growing), stock markets are nervous, critical minerals are just waiting to be hit by China which has a monopoly on them (the US has little to zero production of dozens of these economic and defense critical metals). Meanwhile, US and Chinese consumers have to pay a hidden tax on the higher cost of hundreds of imported goods.
Granted, the trade war winning formula is being reflected in US economic stats which at first blush, look pretty good. In the first quarter, the US economy barreled along at 3.2%. A year ago it was at 4.2%. Economic growth peaked in 2014, at close to 6%, when Obama was president, then dropped under 1% as the US election cycle began, in 2015. Since Trump has taken the helm, the trend line is clearly up. Employment has fallen to 3.6%, which is the lowest since the mid-1960s over 50 years ago. African-American unemployment is at a record low.
After hitting an all-time high of 26,828, on October 3, 2018, the Dow Jones Industrial Average traded sideways until April 5, 2019, when the closing bell rang on a yearly top of 26,424. The S&P 500 is up about 20% since its December low.
The economy has added over 5.4 million jobs since Trump and his team entered the White House.
After a decade of stagnation, real wages (hourly pay accounting for inflation) have grown 3.2%.
An economy that shows those kind of numbers usually has high inflation. But even here, the United States is well within a comfortable range. At 1.6%, it’s actually below the Fed’s 2% target.
June will mark the 10th year of a growing US economy.
But this economy is built on a weak foundation, based on tax cuts and high corporate earnings derived from stock buybacks.
In December 2017 the Trump administration passed the Tax Cuts and Jobs Act. The legislation slashed the corporate tax rate from 35% to 21% and the top individual tax rate shrunk to 37%. It also cut income tax rates, doubled the standard deduction and eliminated personal exemptions.
But the most important change concerned the repatriation of profits that US corporations were holding overseas. Under the Tax Cuts and Jobs Act, companies were incentivized to bring their overseas profits to the United States, where they would be taxed at a one-time rate of 15.5%, which is lower than the regular corporate tax rate of 21%.
Suddenly these companies found themselves flush with cash, and they needed to find a way to spend it. Stock buybacks are a good option because they allow management to stuff cash back into the company, indirectly, by reducing the share float. It makes them their earnings per share look good, which drive fat compensation packages.
In 2018 US companies set a record $1 trillion in stock buybacks. As an example of how companies have used buyback programs to improve their metrics, consider Apple. Since 2012, Apple's buyback program cut its outstanding shares by one quarter, doubled its earnings per share, and ended up with a 150% increase in its share price.
There is clearly a strong connection between repatriation, stock buybacks, and higher-than-normal corporate earnings. Is it any coincidence that half a trillion dollars worth of overseas profits were brought home in 2018, during which time the United States saw the most share buybacks in history, along with sky-high corporate earnings (data firm Refinitiv estimates profit growth among S&P 500 companies at 23% in 2018; S&P stocks were up 13% in the first quarter of 2019, the best Q1 performance since 1998) and a booming stock market? I don't think so. And even though repatriation has run its course, buybacks are popular on Wall Street.
Share repurchases have increased every quarter of the last four quarters, and the buying frenzy is set to continue.
Lower taxes and high corporate earnings are certainly helping the US economy to grow. According to the Congressional Budget Office (CBO), about 0.3% of the 2.9% GDP growth in 2018 can be attributed to the $1.5 trillion tax cut.
The repatriation of corporate profits appears to be a good thing. The problem is, in allowing companies to keep more of their profits, the government is depriving itself of tax revenue. The CBO forecasts the $1.5 trillion tax cut will add $1.5 trillion to the national debt over the next 11 years. How will the government pay for such massive-ticket items as the $2 trillion infrastructure plan just proposed? Print more money I guess, and heave it onto the mountainous debt pile.
The Trump administration like the Reagan adminstration before it, believes that robust corporate earnings will put more money into the hands of workers (the “trickle down” effect) to spend. But that isn't happening. CNN quotes the congressional Joint Committee on Taxation in reporting that two-thirds of taxpayers paid around $100 less in taxes in 2018 (about the cost of a nice dinner for two). In fact the tax cuts worked out much better for those making between $500,000 and a million, who were an average 5.2% richer, compared to households making under $50,000 in 2018, whose after-tax income rose by just 0.6%. The rich are indeed getting richer.
Granted, consumer spending is up ($12.7 trillion in the first quarter of 2018 to $13 trillion in Q1 2019), which is important because it represents two-thirds of the US economy. But as we discovered, when researching what is behind the US economy's strength, this just means more consumer debt. US credit card debt skyrocketed to $870 billion in 2018, a new record.
So, the US is winning the trade war, for now. But what happens after all the overseas profits have been blown on share buybacks, and the tariffs really begin to bite? The US white shirt of the dirty-shirt Western economies might become a tad bit soiled.
Worse, what if the trade war turns nasty, and Beijing decides to pull out the big guns? China could stop buying US Treasuries, which would cause the US dollar to plunge. Or slap embargoes on critical metals like rare earths and lithium, crucial to the new electric economy and the defense of the nation.
Conclusion
Economist Stephen Roach has an interesting take on the trade war. Writing in Project Syndicate, Roach invokes history to expose a parallel between the US trade conflict with Japan in the 1980s, and the current battle with China. He argues that the United States should really look in the mirror, and address its own problems, notably the low US savings rate, before throwing stones at Asia:
Back in the 1980s, Japan was portrayed as America’s greatest economic threat – not only because of allegations of intellectual property theft, but also because of concerns about currency manipulation, state-sponsored industrial policy, a hollowing out of US manufacturing, and an outsize bilateral trade deficit. In its standoff with the US, Japan ultimately blinked, but it paid a steep price for doing so – nearly three “lost” decades of economic stagnation and deflation. Today, the same plot features China.
Notwithstanding both countries’ objectionable mercantilism, Japan and China had something else in common: They became victims of America’s unfortunate habit of making others the scapegoat for its own economic problems. Like Japan bashing in the 1980s, China bashing today is an outgrowth of America’s increasingly insidious macroeconomic imbalances. In both cases, a dramatic shortfall in US domestic saving spawned large current-account and trade deficits, setting the stage for battles, 30 years apart, with Asia’s two economic giants.
I agree with Roach. As much as I am comforted in knowing that America is, so far, beating China, I can’t help thinking, is this all going to come back and bite us in the end?
Richard (Rick) Mills
aheadoftheherd.com
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