Key points

  • Trump has chosen to escalate the trade dispute with China further, which adds to the uncertainty and risk of a trade war.
  • We still believe the US and China will ultimately strike a deal – but it may take longer than expected.
  • It is increasingly likely that the rising uncertainty will weaken the global business cycle in 2018.
  • It may also soon start to affect central banks and could possibly delay or soften their tightening paths.

Yesterday we argued that we were entering a more unpredictable phase of the US and China trade dispute and outlined two scenarios: one in which negotiations start and we end up with a kind of a grand bargain between US and China, see Research – Two scenarios for the US-China trade conflict, 4 April 2018. And one in which we escalate further and enter a real trade war. We also argued the first scenario was most likely.

However, for now we were mostly right about the unpredictability as Trump last night chose the path of escalation by ordering his administration to ‘consider whether USD100bn of additional tariffs would be appropriate… and, if so, identify the products upon which to impose such tariffs’. He also instructed his agriculture secretary to ‘implement a plan to protect our farmers and agricultural interests’ from Chinese retaliation. Not surprisingly, China responded by saying it was prepared to strike back and adopt ‘new comprehensive countermeasures’. It also repeated that ‘China doesn’t want a trade war, but we’re not afraid to fight a trade war’.

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We still believe that the ultimate outcome will be one of a negotiated solution and do not expect Trump to go all the way and enter an all-out trade war. However, it seems things could get worse before they get better. The longer the uncertainty drags out, the higher the probability that we will see this uncertainty feed into lower economic sentiment among businesses and impact real investments negatively for some time while companies await the outcome of the current dispute.

It points to a risk that the current weakening of the global business cycle could be reinforced while the uncertainty prevails. This would normally entail lower bond yields and continued high volatility in equity markets. It could also lead to a delay or soften central bank tightening in both the US and the euro area.

Why we still believe in a solution ultimately

With Trump’s clear message of a further escalation and signs that we are entering a tit-fortat trade war, why do we still believe a solution is ultimately found?

First, we know that Trump’s negotiation style is to scare his opponent as much as possible and seem irrational enough to do things that could have a very high cost. We saw this in the North Korean crisis, where he warned of ‘fire and fury like the world has never seen’, although an attack on North Korea would likely have a very high cost in terms of lives in South Korea. Tripling the amount of goods from USD50bn to USD150bn seems like a response out of proportion and designed to scare China (US tariffs would then comprise 30% of total US imports from China and 1.3% of Chinese GDP) . Trump wants the strongest possible hand going into negotiations with China and his hand is strongest if he seems unpredictable and possibly irrational.

Second, while Trump is now escalating the conflict most of his advisors have done the opposite over the past 24 hours. His new economic advisor Larry Kudlow has said there would be negotiation and it was possible there would not be any tariffs at all. The same message has come from Trump’s commerce secretary, Wilbur Ross, while US Trade Representative Robert Lighthizer was quick to say that any additional tariffs would not go into effect immediately but would be subject to a 60-day public comment period, as would the penalties announced earlier in the week.

Third, Trump will now come under significant pressure from American businesses that fear for their future sales in China. As we mentioned in our piece yesterday, General Motors now sells more cars in China than in the US and a consumer boycott of US goods could hurt them significantly. The same thing goes for a lot of other brands like Coca-Cola, Nike and Apple. Similarly the agricultural sector will be hurt – even if Trump aims to compensate them short term. They would still lose competitive edge in one of the world’s fastest growing markets for the next 10-15 years and lose out on major opportunities here as European and other countries stand ready to take over market shares from US exporters.

Fourth, a trade war with China cannot be won. China’s hand is too strong and they can do too much damage to the US economy both short term and long term. China will not flinch from retaliating if measures are implemented away from the negotiating table or are based on a decision outside of the WTO system. If China does not respond to measures taken outside of the global trade system of WTO it would open a Pandora’s box of other potential tariffs from other countries. China wants a rules-based system, but will likely respect a decision against them within that system. They are aware of the issue with technological transfer related to joint ventures and Chinese Premier Li Keqiang recently pledged they would take action in this area, see Bloomberg, China Pledges Action on Tech Transfer as Trump Plans Tariffs, 20 March 2018.

What now? Always darkest before dawn

Uncertainty prevails currently and we do not know exactly how far Trump is willing to take this before making a deal with China. However, we still believe a deal will be made. With so much at stake, though, for the US and China, both countries may be willing to push each other very hard before striking a deal. Hence, it seems that uncertainty will be with us for some time and that it will have to get even darker before dawn. With that, it is increasingly likely it will have an effect on global activity in the coming quarters. Nevertheless, this effect should prove temporary and be replaced by a rebound when postponed investments come out of the drawer again.

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