Kim Catechis, Head of Global Emerging Markets, Martin Currie (a Legg Mason affiliate)
Last week, President Trump said via Twitter that the US will increase tariff rates on $200 billion in imports from China to 25%, from the 10% rate currently. His tweets said the increase in tariff rates would take effect on Friday (10 May).
If the move was an attempt to get the negotiations closed quickly, or an acceptance that he will not be able to paint the deal as a victory, it was high risk, because the threat essentially forced him to follow through. The reaction from Beijing is always going to be predictable: Xi Jinping is never going to be able to bend in this negotiation. So, the gamble appears to have forced both sides down the road of escalation.
With an eye on the 2020 elections, Trump seems to be prepared to risk more damage to his voter base, in exchange for appearing strong in the trade negotiations, meaning he will continue to demand the impossible from China. Xi is determined to resist and will accelerate development of other export markets – For China, the US is the biggest export market, representing 19% of exports but only 8.4% of imports. But more importantly, what many observers forget is that China’s trade intensity, in other words, the contribution of trade to the economy is relatively low by global standards at 36%*. For comparison, the UK is at 52%, Canada at 63%, Belgium, Ireland, Switzerland and the Netherlands are all well over 100%. The implication is that while China is undoubtedly hurt by the trade wars, the damage is not catastrophic. The US appears less exposed, as its trade intensity is at 25%, but there are academic studies that demonstrate the concentration of the retaliation by trade partners in very localised areas, thus focusing the ‘pain’ (so far) of a trade war on the American Midwest.
For investors, uncertainty is heightened again, and weakness looks set to continue across global capital markets.
At this point, it is the US stock market’s reaction that looks most likely to drive a change of heart in Washington, DC. That and the reaction of the Republican base, bearing in mind the proximity of the electoral season…
Beijing will probably not respond to this intimidation, as ‘face’ would be catastrophically lost, so these new tariffs may well come through – and China’s retaliation is likely to be gradualist but focused once more on the financially strained Republican farm belt. The calculation will be that the agriculture lobby finally breaks cover and applies pressure to the White House. Meanwhile, the US electoral calendar grinds closer and Trump’s window of opportunity to show results starts to close, thus reversing the pressure onto him.
For all the other financial markets in the world, this is an unwelcome injection of more uncertainty, when global economic growth expectations are already weak. If this were to be a prolonged face off, damage to confidence will have serious consequences for capital expenditure decisions.
My base case is that the capital markets had overestimated the chances of a smooth negotiation, so there was always room for disappointment.
*Source: Martin Currie and the World Bank, World Integrated Trade Solution, May 2019. Data to 31 December 2017.