Key Questions: Is Index Investing About to get Political?
The ongoing trade war, which has already morphed into a currency war, could escalate into a financial war.
Later this week, and over the ensuing several weeks, numerous important trade-related events and deadlines will be looming large. At the end of this week, US and Chinese officials are scheduled to meet in Washington to resume talks. For those needing a scorecard to keep track of the tariffs on Chinese imports announced thus far, including when they took/will take effect, what follows is a summary according to the USTR (US Trade Representative) Office:
- July 6, 2018 – 25% tariffs applied to $34B (billion) of goods; raised to 30% on October 15, 2019
- August 23, 2018 – 25% tariffs applied to $16B of goods; raised to 30% on October 15, 2019
- September 24, 2018 – 10% tariffs applied to $200B of goods; raised to 25% on May 10, 2019, and then raised to 30% on October 15, 2019
- September 1, 2019 – 15% tariffs applied to $112B of goods
- December 15, 2019 – 15% tariffs applied to $160B of goods
Based on experience, handicapping what will transpire next is difficult, and the recently launched impeachment inquiry makes it even more challenging to gauge the president’s appetite for negotiation. That said, there is a growing consensus that we have reached the zenith of tariffs increasing.
Importantly, this view does not imply that tariffs will be rolled back, though some could in exchange for China’s purchase of US agricultural products, among other things. But the threat of additional tariffs may have peaked, although we would caution against becoming overly complacent with this opinion.
As we have argued before, purchasing US crops is a positive development; it is also tangible, and it resonates with many who voted for President Trump in 2016. On the other hand, theft of intellectual property, forced technology transfer, and subsidization of state-owned enterprises are not easily understood by most Americans and are far more complex to resolve. And yet these are the issues Trump and his advisors are focused on. This has been the basis for our view that trade tensions may persist even if the threat of new tariffs has diminished.
Furthermore, we have observed several other developments that suggest the ongoing Trade War, which has already morphed into a Currency War, could further escalate into a Financial War, signifying that US/China relations may have been permanently altered.
Six weeks ago, US Senators Marco Rubio (R-FL) and Jeanne Shaheen (D-NH), members of the Committee on Foreign Relations, sent a letter to the Federal Retirement Thrift Investment Board (FRTIB, the organization that manages billions of retirement assets of federal government employees) urging the Board to reverse its decision to select an index fund for its retirement plan.
The index in question is the MSCI All-Country World ex-US Investable Market Index (MSCI ACWI ex-US IMI), arguably the broadest index for non-US equities. FRTIB’s decision, made nearly two years earlier, was based on its desire to select an index that offered broad market exposure, liquidity, and low transaction costs, all worthy attributes.
Senators Rubio and Shaheen, however, are concerned that because the MSCI ACWI ex-US IMI includes companies domiciled in China, FRTIB’s decision is effectively using retirement savings of federal government employees, including members of the US Armed Forces, to fund the Chinese government’s efforts to undermine US economic and national security. The letter also criticized the Board for their inadequate selection process, stating that "no evidence related to national security, human rights, or financial transparency was ever performed."
MSCI -– a leading index provider -– may have unintentionally invited Washington’s attention when it decided in late February to quadruple the allocation to Chinese companies within the MSCI ACWI ex-US IMI, a decision largely based on the rise of China’s prominence within the global economy. After all, this index (like the more familiar S&P 500) is capitalization-weighted, meaning that as a company’s stature amongst investors rises, the larger its representation within a given index it becomes.
Two weeks ago, several news outlets reported that the Trump administration was considering removing Chinese companies from US stock exchanges, imposing limits on investments in Chinese markets by US federal retirement funds and capping the allocation to Chinese companies within indexes such as the MSCI ACWI IMI. Administration officials were quick to respond that no such actions were being contemplated but they included an important caveat "at this time" when downplaying the story.
Meanwhile, various House members, including both Democrats and Republicans, have introduced related legislation. Such bipartisan support is exceedingly rare in Washington. But it illustrates that being tough on China remains a politically popular position that is likely to persist regardless who is elected president in 2020.
Troublingly, China was said to be considering its own "entity list." Thus, the Financial War may have begun. As such, we reiterate our statement that US/China relations may have been permanently altered. We also repeat our view that when constructing portfolios, flexibility and diversification remain of paramount importance as geopolitics become increasingly volatile.
For more information, please contact your Key Private Bank Advisor.