In recent years, many financial commentators have been predicting the end of globalisation and a move into a multi-polar world order, with disenchantment over widening income and wealth distribution driving a changed environment. The US trade war with China is an obvious recent example. In this commentary, we consider the medium-term outlook for the trade negotiations and how these might affect financial markets and economies.
The US’s initial justification for embarking on the trade dispute with China was the protection of US manufacturing jobs from unfair competition from subsidised Chinese state-owned enterprises.
However, it has quickly become evident that the disagreements go much wider and deeper than early signs suggested. Issues around intellectual property rights, data and national security have now entered the scene. The talks are now so broad and complex that a short-term compromise seems unlikely.
President Trump has long accused Beijing of using intellectual property theft and artificial currency devaluation to gain competitive advantage, vowing to tackle America’s annual trade deficit with China, which now exceeds $400billion. Last year the US imposed tariffs on $250billion of Chinese imports. Beijing hit back with similar duties on $110billion of imported US goods.
In December both countries agreed to halt new tariffs and after subsequent negotiations, it seemed those already imposed would be reversed. Instead, after yet another Trump Twitter tantrum, the US upped the stakes, raising existing tariffs from 10pc to 25pc on 5700 categories of Chinese goods. Beijing retaliated once more.
Clearly, there is more at stake than the terms of trade. It is the rise of China and the possibility it may overtake the US as the world’s greatest power that is the real issue. At the beginning of Donald Trump’s regime, some economists suggested that before he left office, China would overtake the US in terms of the size of its economy. Since then, however, US growth has accelerated substantially while the Chinese economy has remained at a similar level, pushing the date further into the future. However, it is that threat that is driving the US’s stance. Similarly, China has the stated aim to regain the position as the world’s greatest power and it is pursuing a clear plan to achieve it.
The conflicting goals of both sides are not the only barriers to a resolution, there are also cultural differences between the parties, as evidenced by the Chinese citing the tone of the agreement as a barrier to settlement. Additionally, there are very different political systems confounding the process. The Chinese are able to take a multi decade, if not multi-generational, approach to the achievement of their goals, so long as domestic living standards are improving at a rate that keeps the current regime in power. The US faces a four-year election cycle which leaves only a narrow window where short term pain can be tolerated, without risking a change of leadership. The Chinese clearly have the advantage here unless tariffs are raised to such a level that material amounts of substitution of Chinese goods with other suppliers can occur, a process that inevitably takes time.
Also occupying a prominent place in the bilateral US—Chinese economic relationships is the $16 Trillion US Treasury bond market. As the world’s two super-powers escalate their rivalry, Investors also worry about whether China will abruptly use it’s $1.1 Trillion holdings of US Treasuries as a trade war financial weapon. China’s stake along with other foreign buyers in American debt has helped to contain US interest rates over the years, enabling Washington to spend and push the federal deficit higher and higher.
However, in spite of the speculation concerning a dramatic exit from the US debt market, Beijing is likely to continue playing the long game. Treasury yields will trend lower as the economic cycle ebbs and the desire among other investors for owning government bonds means China can exit near the top in price terms and gradually pivot away from the US and focus on rebalancing its own economy.
In summary, it comes down to the pain threshold of the negotiating parties as much as the perceived benefits of a resolution. While near term compromises are possible, in the long run further disputes are inevitable particularly as China is no longer perceived as an opportunity for US companies but is now a threat to the US on many levels. The market implications for this major change are much more nuanced than the near-term reactions we have seen so far. Some of the implications include slower growth and marginally higher inflation in the US and an even greater need to reposition the economy towards a domestic growth strategy for China.
As with most intractable problems, the most sensible investment strategy is to avoid speculating on the unknown, in this case by avoiding the obvious losers such as companies with a high dependence on Chinese supply chains.
Investors understandably suffer tariff terror but in reality, the threatened tariffs are too small to cause the economic damage commonly imagined. It is a fear of a small negative but one that can also present an opportunity for investors.
Markets have consistently underestimated the persistence of the trade war, assuming that it is everyone’s best interests to find a quick solution. As stock markets come to the view that this is an issue that isn’t going away, investors are likely to increasingly price in the risk and learn to live with it. No doubt markets will soon move on to worrying about some other new issue, while continuing to climb the wall of worry.
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