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Economy

Bracing for US-China ‘Trade War Today, Trade Deal Tomorrow’

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Bracing for US-China ‘Trade War Today, Trade Deal Tomorrow’  

 

  • Market response to the latest escalation of US-China Trade war has been muted so far. The negative sentiment has limited itself to Chinese stocks with the Shanghai Composite falling almost 5.0% since the start of last week while declines in US and European stocks have been half that. In FX, sentiment has also been fairly muted with USD (a safe haven in times of crisis) dropping a mere 0.2% since the escalation of the crisis.     
  • Citi analysts remain cautiously optimistic on a US-China trade deal by the end of 2Q-19 even as China has vowed to retaliate.  Consensus is that Trump is likely using the tariff hike as a negotiation ploy and his threat to raise tariffs on the remaining USd325bn of Chinese imports is to pressure China to a quicker consensus on the trade deal  while saving him face from the difficult domestic issues surrounding his presidency. The timeline for a ‘Trade War Today, Trade Deal Tomorrow’ now depends on how fast China comes back to the table.   
  • So the current damage is likely to be limited unless there is a miscalculation by either side that results in (1) a complete breakdown in talks that extends the time line well beyond the end of 2Q, or (2) the US raises the stakes further and imposes a 25% tariff on the remaining USD325bn of Chinese imports which Citi analysts think could come as early/mid-July.
  • With the US increasing tariffs from 10% to 25% on a further USD200bn of Chinese imports on Friday, the  opportunity window for avoiding a trade war is closing fast. Citi analysts view that if a trade deal is not done by the end of 2Q, the relative growth dynamics between the US and China in 2H-19 would lessen the US leverage over China to strike a deal.  
  • The likely impact of the recently announced tariff increase would lower Chinese growth by ~0.5pp and global growth by 0.2pp over the next 1-2 years. But additional tariffs to cover all Chinese imports (a total of $575bn) could have more than twice the impact on China’s growth and ultimately impact the US and the global economy.  The impact on the US is likely to come via higher Inflation that could complicate the Fed’s bias to ease policy to cushion the impact on the US growth outlook.
  • Impact on the rest of the world is likely to come via spillover effects through more vulnerable supply chains with Taiwan, Thailand, Malaysia and Korea while Mexico and Canada could benefit from US trade diverting away from China, as well as Vietnam and Malaysia; 2) higher uncertainty and its impact on business sentiment and investment; and 3) a potential tightening of financial conditions.                    

 

How have markets reacted to prior US tariff threat pronouncements on China and possible strategies 

  • Rates: US 10yr bond yields on average declined for about a week before resuming an upward move following each announcement. However, with the threat of further escalation looming, investors may consider adding to long duration strategies should yields back up.
  • Equities: US equities dropped in the days after the announcement of the Section 301 investigation (March 22, 2018) and the first set of tariffs on $50bn of Chinese imports (June 15, 2018) and more recently last week while EM equities declined after each announcement. With the threat of an extended stalemate looming, EM equities are likely to remain under pressure while DM equities, bolstered by the global central banks’ dovish pivot (particularly the S&P500) could also see a more extended decline if the US and China either extend the trade dispute or the US decides to extend tariffs on all Chinese imports.
  • Exchange rates: USD was relatively flat through the first 2 weeks from each announcement on average but strengthened afterwards against a basket that includes CNY and EUR.  Meanwhile, DM currencies strengthened relative to EM after each announcement. A similar response is expected this time around with demand for safe haven currencies (JPY, CHF and USD to a lesser extent) likely to rise as investors reduce exposure to EM (CNY) and G10 risk currencies (AUD & NZD).
  • Commodities: Metals and gold prices weakened after the announcement of tariffs on average, while oil prices strengthened. In this recent episode, the commodity complex is pricing in a more than -10% drawdown in global trade volume growth but that could extend further should the US and China either extend the trade dispute or the US decides to raise tariffs on all Chinese imports.    

 

 

 

 

 

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