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An escalation in the US-China trade war?

The US-China trade war continues to escalate, with China announcing on 22 August that it would impose additional tariffs on $75 billion worth of US goods. The US retaliated swiftly, stating it would increase tariffs from 25% to 30% on $250 billion of Chinese imports from 1 October.

What happened?

  • On 22 August China announced that it will impose additional tariffs on $75 billion worth of US goods including soybeans, automobiles and oil. An additional 5% tariff will be placed on soybeans and oil from 1 September. The 25% duty on US manufactured cars, which were previously suspended, will resume on 15 December.
  • The US retaliated swiftly and announced that the existing tariffs on $250 billion of Chinese imports will increase from 25% to 30% starting 1 October. Tariffs on another $300 billion worth of other Chinese imports would increase from the previously announced 10% to 15% effective 1 September. In effect, President Trump cancelled his previous deferment of tariffs on around $150 billion of imports.
  • President Trump also tweeted, “We don’t need China and, frankly, would be far better off without them. Our great American companies are hereby ordered to immediately start looking for an alternative to China, including bringing your companies HOME and making your products in the USA.”
 

MARKET REACTIONS

  • The S&P 500 fell by 2.6%, the Dow Jones fell by 2.6% and the NASDAQ corrected by 3.0% on 23 August. Stocks which have heavy exposures to China fell sharply, including the Apple share price which fell by 4.62%.
  • Sovereign bond yields fell dramatically. US 10 years bond yield fell by 7.9 basis points to 1.538%, German 10 years bund yield fell to -0.672% (the negative sign is not a typo!).

ANALYSIS

  • The latest escalation in the trade war is taking the world precariously close to the brink of all-out economic warfare between the two largest economies.
  • The timing of the Chinese increase on tariffs surprised markets. Most observers expected a period of temporary truce since President Trump’s recent deferment of 10% tariff on $150 billion worth of Chinese exports to US until 1 December.
  • The latest Chinese move has a strong geopolitical element. The relationship between the world’s two largest economies is now at its lowest ebb since the Tiananmen Square massacre in 1989. China is outraged by various developments over the past week. Those include the proposed sale of F-16 fighters to Taiwan (the first sale of US fighters to Taiwan since early 1990s) and the stern warnings by prominent US politicians (including Nancy Pelosi, Speaker of the House of Representatives, and Mitch McConell, Senate Majority Leader) to China over the situation in Hong Kong.
  • The response from the US was swift and harsh. President Trump’s rhetoric rattled markets. It is not clear if President Trump is serious in ordering US companies to withdraw from China. There are also some doubts on the extent of his authority. Under the International Emergency Powers Act (IEEPA), a US President can declare a national emergency and use that context to regulate commerce, as long as the economic actions affected are tied to the interactions with people or nations associated with the state of emergency. Congress does have the power to end the state of emergency, although there is a grey area as to whether this power extends to order US companies to exit their existing investments in China.
  • A declaration of national emergency over China by Trump is akin to pushing the nuclear button on US-China economic relationship!
  • The magnitude of the fall in equity markets reflects the high level of uncertainty on the outcome of the US-China trade war. It is difficult to envision a speedy resolution of the trade war. Further escalations cannot be ruled out. In fact, the worst case scenario of a de-coupling of the Chinese and American economies, while still a low possibility event, has become more likely.
  • The recent equity market corrections took place in an environment of weakening global economic growth. While US economic growth remains respectable, the latest data suggested that Germany, the largest economy in the Eurozone, may have entered a recession. Investors have also been disappointed by the persistent weakness in Chinese economy after the adoption of more expansionary policies in H2 2018.
  • The escalation in the trade war and recent market developments reinforced the pro-easing biases of the main central banks, including the Reserve Bank of Australia, which recently warned of the risks posed to the Australian economy by the trade war. Markets now fully expect a 25 basis points reduction is US policy rate after the Federal Reserve’s FOMC meeting on 17 and 18 of September.
  • Markets will be closely monitoring any news and policy initiatives from the G7 meeting in France, from August 24–26, 2019.

 

Written by George Lin, Senior Investment Management, Colonial First State

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