U.S.-China Trade War: Could it get any uglier?

A day will come when there will be no battlefields, but markets opening to commerce and minds opening to ideas.
— Victor Hugo

Trade tensions between the United States and China show no signs of simmering down. A new round of U.S. tariffs on Chinese imports kicked in on August 22. The U.S. began collecting an additional 25 percent in duties on $16 billion in Chinese import product categories including semiconductors, chemicals, and motorbikes, just to name a few. These latest American tariffs come on the heels of $34 billion in Chinese goods duties levied at 25 percent, which were implemented in July.

Beijing immediately retaliated with tariffs of their own on $16 billion worth of additional imports from the U.S. including fuel, steel products, autos, and medical equipment.

In brief:

  • Basic materials, industrials, and emerging markets have all taken a hit in recent months due to the trade wars. Turbulence will be around for awhile particularly in emerging markets.

  • Markets should expect bilateral tit-for-tat trade actions to continue for the foreseeable future for both the U.S. and China. With approaching midterms, China is playing a waiting game.

  • The objective is to reduce the size of the U.S. - China trade deficit from an estimated $370 billion to $200 billion by 2020 and eliminate unfair trade practices noted below.

August 6, 2018 - prior to recent round of 16b in tariffs

August 6, 2018 - prior to recent round of 16b in tariffs

The issues:

At the core of the trade war issues on the U.S. side are concerns over technology infringement and alleged widespread intellectual property (IP) theft by the Chinese. This comes from three activities:

  • Corporate espionage,

  • Cyber-theft, and

  • Technology transfer to the Chinese in exchange for market access.

The Commission on the Theft of American Intellectual Property estimates that China's purported IP theft costs the U.S. between $225 billion and $600 billion each year. http://ipcommission.org

China has denied Washington's allegations that it essentially forces the unfair transfer of U.S. technology in exchange for market access and insists it adheres to World Trade Organization rules.

Instead of tit-for-tat trade tariff retaliation with the U.S., China should follow South Korea's lead and accept to bring down their large surplus on American trades and rebalance a relationship that has served them so well.

The art of the deal

The prevailing wisdom on President Trump's trade tactics is that he's making major negotiation errors in his attacks on China and that nobody can win a trade war. Regardless of the Trump administration’s current trade war strategy with China, I think that things could change quickly for China in the coming months leading to two very different potential market outcomes in Q4. China wants U.S. business interests to pressure President Trump, and it’s betting on scenario one below.

Scenario 1: A “Blue Wave” in the House this November gives the Democrats a mandate to impeach Trump if the Special Counsel report proves some form of perjury or Russian collusion. President Trump is likely to survive indictment in the Senate, but "Never Trump" Republicans could vote to replace him with Vice President Mike Pence. Note: The billionaire Koch brothers have financed the Vice President’s political career, and therefore, he would likely carry their “free trade” globalist torch.

Scenario 2: The Special Counsel finds no Russian Collusion or wrongdoing by the Trump administration, there’s a “Red Wave” in November midterms, and President Trump is given the mandate to move forward with his populist agenda and impose tariffs on a total of $500 billion of Chinese imports.

So, what’s the real U.S. endgame in this trade war with China? It's this: Redirect global supply chains to favor American manufacturers; pressure China to open its market to Americans with no strings attached; reduce the trade deficit, and challenge Chinese dominance in Asia.

The bottom line:

Shangai index 620x-1.png

China's President Xi Jinping is feeling the heat and it looks like he may have overreached. Trade tensions have exposed vulnerabilities in China's slowing economy, and it’s making investors nervous. A tanking Chinese stock market and resulting investment outflows could lead to an uptick in emerging market bond yields and the winter of discontent in China. Even worse, a full-blown trade war would have stagflationary consequences globally.

A few days ago, veteran Wall Street trader Art Cashin of UBS mentioned on CNBC that markets seem to be pricing in the “Pence Put.” A put is a option contract giving the owner the right to to sell a specified amount of an underlying security at a specified price within a certain time frame, limiting downside market risk. Either the market is looking beyond the trade war and midterm elections and pricing in a "Pence Put" or it's having a lagging reaction to significant regulatory rollback and Trump's Tax Cuts and Jobs Act of 2017 (TCJA).

The future is capricious (especially in the Trump era), which is partially the reason why markets exist in the first place. The market conditions that led to February’s spike in the VIX (volatility index) — rising rates, less liquidity, and hedge funds being caught wrong-footed — are still there. With the unprecedented confluence of political and trade events added to these pre-existing conditions, the likelihood of a spike in volatility calls for underweighting equities relative to their strategic asset allocation and holding higher levels of cash. Depending on the outcome of the November midterms and the Mueller investigation, the U.S. - China trade war could get even uglier in the months ahead as trade policy scripts get torn up and rewritten.

Sources: Wall Street Journal Online; Bloomberg News; Investor’s Business Daily; Forbes.com; CNBC News; Reuters News; The Economist.

The information contained in this piece is intended for information only and should not be considered investment advice. Please contact your financial adviser with questions about your specific needs and circumstances.

The information and opinions expressed herein are obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by Cambridge Wealth Management, LLC. Opinions expressed are current as of the date of this publication and are subject to change. Certain statements contained within are forward-looking statements including, but not limited to, predictions or indications of future events, trends, plans or objectives. Undue reliance should not be placed on such statements because, by their nature, they are subject to known and unknown risks and uncertainties.