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Global Trade Friction—World of Conflict—A Second China “Trade Shock”—Further Deindustrialization of Developed Countries—Creates Critical National Security Risks for U.S.—Focus on North America and Productivity Improvement—AIS hift to On-Device Generative AI

Date Posted: May 30, 2024

Global Trade Friction—World of Conflict—Increased Regionalization—Focus on North America

Financial markets and the media focus on when and how many times the Fed will cut its funds
rate in 2024, alongside inflation concerns. Beyond the current investment focus, the world of
conflict and the threat of a second “trade shock” from China could further deglobalize world
trade due to increased trade enforcement measures. This trade friction will influence global
growth and financial markets for some uncertain period into the future. In the United States,
industrial policies and higher import barriers will likely increase the focus toward returning
production and service industries to North America.

The First China Trade Shock Reduced Manufacturing’s Share of Employment—AI and
Automation will Continue that Trend—A Second Trade Shock would further Deindustrialize
the U.S.

The first trade shock occurred when China joined the World Trade Organization in 2001 as a
“non-market economy.” China leveraged this membership to export its low-cost labor—at just
3% of developed countries’ wages–in the form of products to the world (see Figure 1.) The
rapid increase in Chinese exports to the United States peaked around 2010 (see Figure 2.)
Various studies estimate that roughly one million American manufacturing jobs disappeared in
the first decade of this century (see Figure 3.) Automation further pressured the loss of low-
skilled manufacturing jobs. Since the peak impact in 2010, U.S. manufacturing employment
stabilized; nonetheless, many affected regions did not see any job recovery. Longer-term,
automation and AI technologies will continue to reduce the manufacturing share of overall
employment. Even in China, according to Dani Rodrik at the Harvard Kennedy School,
manufacturing employment declined in both numbers and share of total employment for more
than a decade.

Figure 1
Share of Manufacturing Exports, 1980-2020

Sources: World Bank, Center for Strategic & International Studies

Figure 2
U.S. Manufacturing Imports from China and Southeast Asia

Source: On the Persistence of the China Shock—David Autor, David Dorn, Gordon H. Hanson

Figure 3
All Employees Manufacturing

Sources: U.S. Bureau of Labor Statistics, fred.stlouisfed.org

China’s Low Consumer Expenditures forces Manufacturers to Export their Overcapacity

Despite its huge consumer market, China cannot fully absorb its rapidly expanding production
due to President Xi Jinping’s view of stimulating consumer spending as “Welfarism.”
Consequently, China’s consumption expenditures represent less than 40% of GDP, compared
with 65-70% in the United States and lower than other Asian countries (See Figure 4.) This limits
demand for both domestic and foreign products, exacerbating the trade deficit. The
government indirectly encourages personal savings by providing limited healthcare and
retirement benefits (see Figure 5.) High savings rates distort China’s economic structure by
emphasizing investment over consumption, leading to an imbalance where manufacturers must
rely on exports to absorb their excess capacity.

Figure 4
Final Consumption Expenditures % of GDP, China, U.S. Japan 1970-2021

Sources: World Bank, Hinrich Foundation

Figure 5
China’s Savings Rate vs. Other Asian Economies (% of GDP)

Source: CFR, Noah Smith

China’s Sizeable Personal Savings Deposits Enable China’s Banks to Supply Ample Credit to
Support Excess Manufacturing Capacity for Export—Offsets Real Estate Collapse


China’s industrial policy support totals more than double that of the United States as a share of
GDP. To offset its real estate market crash, China refocused its sizeable industrial policy to
rapidly expand manufacturing and industrial capacity beyond domestic needs. The sizeable
personal savings deposits in China (see Figure 6) enabled banks to finance this expansion in
support of government policy by often providing credit at below market rates. At the same
time, the government provides subsidies enabling manufacturers to export their excess
production at under-market pricing.

Figure 6
China’s Industrial Loan Surge (Tn RMB)

Sources: WIND, @ShanghaiMacro, Noahopinion

China’s Export Policies Raises Backlash Leading to Trade Friction, Inflation and Global Growth
Pressures

China’s growing excess production could trigger a second trade shock greater than the initial
one, if not restrained. This possibility raises concerns among both developed countries and
nations in the “Global South” such as Brazil and India. While China moved some final assembly
operations to South-East Asian countries and Mexico, it will not reduce the shock affect of its
trade policies (see Figures 7 and 8.) The resulting global backlash against China for dumping
products will increase global trade friction, depress global growth, and increase inflationary
pressures. Despite this, both U.S. political parties seem to adopt the thinking of former
President Trump’s International Trade Representative, Robert Lighthizer, who said, “it was worth
trading higher consumer prices for increased manufacturing employment,” as quoted in the
New York Times

Figure 7
China Exports to South-East Asia more than U.S (previous 12 months $bn)

Sources: IMF DOTS, @FT

Figure 8
Percentage of U.S. Goods Imports

Source: Census Bureau

China’s Dominance of Global Manufacturing leads to Deindustrialization of Developed
Countries—Results in National Security Risks for the U.S.

The world’s dependence on China as the factory to the world leads to deindustrialization in
developed countries, particularly the U.S., posing critical national security risks (See Figure 9.)
During World War II, the U.S. produced one B-24 bomber every 59 minutes, today, it struggles
to produce sufficient artillery shells which require machine tools and an experienced workforce.
Over the past two decades, China developed the practical skills to manufacture complex
products, a capability that requires production experience beyond an engineering degree. The
U.S. lost many of those skills due to Chinese exports replacing domestic production. Our
February 2nd Commentary outlined why this era of global conflict and redefining globalization
will lead to a North American Decade. Our March 18th Commentary discussed U.S. Industrial
Policy aimed to reinvigorate domestic production in North America crucial for both commercial
and national security reasons.

Figure 9
World’s Biggest Manufacturing Economies

Source: CFR. Asia Times

Investment Conclusions

Equity-Improving North American Productivity: Investors face challenges brought on by a
world of conflict producing changes to global trade. In our view, there will be a refocus on
returning production of critical and emerging technologies and services back to North America.
To moderate the inflationary impact of that shift, business will look to increase efficiencies
through robotic automation and generative AI. Specifically, there will be a shift in generative AI
from running on the cloud to on-device generative AI processing, akin to the shift from
mainframe to personal computing. Investors should seek out those companies that will lead to
improving productivity through the transition to generative AI processing on laptops, tablets,
and smart phones and increasing the use of robotic automation in manufacturing processes.

Equity—New Sources of Electric Energy to Power Hyperscale Data Centers: Our March 18th
Commentary detailed the growth of hyperscale date centers and the resulting increase in
electric demand. Since then, investors focused on the traditional utilities in regions of dense
hyperscale construction. In our view, location and environmental concerns will drive data
centers away from the utility grid towards micro-grids and on-site battery energy technologies.
Investors should be seeking out those suppliers of such energy sources.

Equity—ETF’s and Active Funds: The complexity and timing of a world in conflict will affect
various sectors, necessitating a broader investment approach. This suggests using a diversified
group of specialized sub-sector ETF’s. Alternatively, actively managed funds led by experienced
managers and their teams that can flexibly adjust to the changing global circumstances would
likely provide a second solution.
Fixed Income: The Fed seems less inclined to reduce the funds rate multiple times this year.
Nonetheless, based on comments from Fed officials, they may still cut the funds rate at least
once this year. If this scenario unfolds, investors in short-term fixed income investments will
encounter increasing reinvestment risk. We previously noted that Treasury notes and bond rates
offer attractive rates of return for the first time since the Great Financial Crisis and suggested
extending duration. While this strategy still appears suitable, it should be implemented more
gradually in line with the reduced rate cut expectations from the Fed.

Alternatives: Amidst changes in the financial industry and markets, alternatives offer
diversification benefits by being less correlated with stocks and bonds. Alternative investments
can both help manage risk and potentially enhance returns.