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The hidden threat from Trump’s trade war that isn’t priced into the ASX

The deepening trade war between the world’s two biggest economies is bad news for global growth and has opened the door to a new risk that most investors have not caught on to yet.

This unintended consequence from the escalating spat between China and the United States is interest rates, which look set to rise more quickly than credit or equity market are pricing in at the moment, as China hinted that it will cut back on its purchases of US government debt (known as treasuries).

China is the biggest foreign buyer of US treasuries and holds US$1.17 trillion worth of US debt, or around 19% of all foreign purchases, according to Bloomberg.

The reminder by the Chinese government that it holds the US by its, erm… uncomfortable area, is the reason why other US presidents have been cautious in its dealings with the Asian giant.

This anxiety prompted then US Secretary of State Hillary Clinton to comment privately to our ex-Prime Minister Kevin Rudd in 2010: “How do you deal toughly with your banker?”

But fools rush in where angels fear to tread, and US president Donald Trump has jumped in head first at a time when the US is looking to issue more debt to pay for his generous tax cuts.

If China steps back from the Treasury market, the excess supply of bonds will likely drive up bond yields. The impact on yields will be even more stark if China goes one step further and decides to sell its holdings of US treasuries at a time when the US attempts to sell new debt issuances.

You can imagine how far the price of Treasuries could fall and price and yields move in opposite directions!

The sharp rise in Treasury yields will hurt not only credit markets but equity investors as well. The treasury market is the benchmark for global debt (including sovereign bonds from other countries), and a faster than expected rise in treasury yields will almost certainly mean a higher cost of capital for everyone.

What’s more alarming is that this can happen even if central bankers abandon their tightening bias.

This is bad news for equities, including those on the S&P/ASX 200 (Index:^AXJO) (ASX:XJO), as the rising cost of debt will crimp earnings growth and stock valuations. Stocks are typically valued on a discount rate that is benchmarked to the risk-free rate. Guess what the risk-free rate is referenced to?

Interest rate sensitive stocks like AGL Energy Ltd (ASX: AGL) and APA Group (ASX: APA) will likely be among the first to feel the pressure if this comes to pass; while our big banks that include Commonwealth Bank of Australia (ASX: CBA), Westpac Banking Corp (ASX: WBC), National Australia Bank Ltd. (ASX: NAB) and Australia and New Zealand Banking Group (ASX:ANZ) will face a margin squeeze given their dependence on offshore funding.

It’s times like this that the words from former US presidential advisor, James Carville, ring in the ears of investors when he said in the early 1990s that he would like to be reincarnated as the bond market because “you can intimidate everybody”.

What President Trump has failed to realise is that China has effectively become the bond market.

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Motley Fool contributor Brendon Lau owns shares of AGL Energy Limited, Australia & New Zealand Banking Group Limited, National Australia Bank Limited, and Westpac Banking. The Motley Fool Australia owns shares of National Australia Bank Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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