Key points

  • We are entering a crucial phase in the US-China trade conflict.
  • We see two possible scenarios: (1) negotiations and a ‘grand bargain’ and (2) Donald Trump strikes back again and we enter a trade war.
  • Scenario 1 is the most likely in our view, which should eventually lead to relief in financial markets

‘Phase two’ of the US-China trade conflict is now over and we are starting to enter more uncharted waters. Both ‘Phase one’, with tariffs on steel and aluminium, and ‘Phase two’, with the latest round of Donald Trump tariffs in defence of US technology – and China’s retaliation, have been running according to the script that has been laid out by Trump and China over the past seven to eight months. We generally knew from Trump’s communication that both these two salves of tariffs were going to come and we also knew from China’s messages that there would be retaliation.

The uncertainty is what happens next. The well-signalled plans end here and it is time for the two countries to work their way forward without a script. This also means that we are entering the most crucial phase of the trade conflict, where it is uncertain what happens next. What we know is that there will be a hearing period in the US of at least 30 days and that China has not said when the new measures will be effective. In general, we see two possible scenarios unfolding from here.

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Scenario 1: Negotiation and a ‘grand bargain’: US Commerce Secretary Wilbur Ross has signalled for some time that the measures are part of a negotiation and said on Wednesday that ‘even shooting stars end with negotiations’. He refrained from naming any timing of talks, though. Trump’s new top economic adviser Larry Kudlow said on Wednesday that it is possible the tariffs will not be implemented ant that it was primarily aimed at sending a ‘message’ to the Chinese. Over the coming month, there will be a hearing period in the US and plenty of internal pressure from the agriculture lobby and other US companies that are very worried about the risk of getting a competitive disadvantage on the fastest growing market in the world in many areas. Americans For Farmers & Families said in a statement that ‘Just as members of President Trump’s own cabinet have warned, America’s food and agriculture industries are now taking a direct hit – and our farmers and families will pay the price’.

Trump is currently playing all his cards to put pressure on China. The tariffs have happened alongside a much tougher stance on Taiwan, as a law has just passed Congress encouraging diplomatic relations with Taiwan, which China has deemed a clear break with the One- China policy. It is likely Trump is seeing Taiwan relations as a bargaining chip in the negotiations. Trump’s aim may very well be to put maximum pressure going into a negotiation to get as many concessions from China as possible. We have seen this many times before in his tactics on making deals.

So, a possible scenario is that behind the scenes the US and China make a ‘grand bargain’ over coming months that involves the US backing down from the Taiwan issue and reducing the amount of tariffs on Chinese goods in exchange for better access for US companies in China and a rising effort in China to protect intellectual property rights and stop requiring transfer of technology in joint ventures. China’s premier Li Keqian recently signalled this was already on the way (see Bloomberg).

Scenario 2: Trump strikes back again and we enter a trade war: Another scenario is that Trump strikes back in a tit-for-tat move that leads to further Chinese retaliation and the whole thing escalates into a real trade war. So far, the amount of USD50bn is only 0.3% of US GDP. As highlighted by Wilbur Ross on Wednesday, this is hardly something that will give a big hit to the US economy. However, if it spins out of control in a continuous escalation, we will have a trade war with no winners, which could lead to a hit to the global economy and further sell-off in equity markets. So far, we have not seen any comments from the US administration that signal it will strike even harder following the Chinese tariffs. However, it is probably still too early to say.

So, which scenario is it going to be? We believe scenario 1 is the most likely. Whether we call it a ‘a grand bargain’, or simply just that things stop escalating and we end up with lower amounts and/or tariffs, the result should be that the big fear of a trade war will soon start to fade. In this scenario, we should see equity markets recover on a decline in risk premium that has gone up lately due to the rise in uncertainty.

The main argument in favour of scenario 1 is that neither of the countries has any interest in a trade war that could do significant damage to both economies and have no winners. In addition, both countries have strong cards in their hands, so neither one can really trump the other.

Who has the strongest hand? No one really

China’s biggest trump card is probably that it is the fastest growing market in the world and is likely to be so over the next 10 years as well. General Motors sold around four million cars in China in 2017 and it has topped GM’s car sales in the US, as it sells 39% of its units in China versus 30% in the US. Even a mild consumer boycott in China on US brands could be detrimental for GM, as well as for other US brands such as Apple, Nike and Coca-Cola. China’s middle class is set to grow from around 300 million people to 600 million over the next decade and this is not a market on which anyone wants to miss out.

The strongest card the US has on its hand is that it is China’s biggest export market, with around 20% of exports out of China. A strong hit to these would clearly be felt in the Chinese economy and could for a while derail the ambition to increase the quality of growth as China might have to resort to another boost to infrastructure spending to close the demand gap from lower exports. This is a path that entails more lending and a risk of overinvestment – a development from which China is struggling to get away.

We now have to wait for the hearing period in the US to evolve and see whether US tariffs will actually be implemented, whether the amount increases or goes down and how Trump reacts to the Chinese retaliation. We may be in a bit of waiting period for now. However, it is not impossible that we have seen the worst on the trade front for now.

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