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Weekly Wrap – A dangerous time for US–China trade tensions

Week ending 8 May: The quiet in markets was drowned out by the noise of US–China tensions, just months after the phase-one trade agreement was signed. Senior Investment Manager George Lin explores this volatile relationship in more depth in the latest Weekly Wrap.

       Written by George Lin
Senior Investment Manager | Colonial First State
 

 

 

Pandemic headlines concentrated largely on restarting economic activity last week, but despite positive sentiment on the reopening of world economies, financial markets were alarmed by US–China tensions – which escalated again, just months after the phase-one trade deal was signed. Markets also focused on incoming poor economic data, mixed corporate earnings, and a potential resurgence of Coronavirus cases – all of which weighed somewhat on global share markets over the week. In Australia, while the government loosened lockdown restrictions, the Reserve Bank of Australia (RBA) forecasted higher unemployment and lower economic output. By Friday, the ASX 200 was up nearly 2.8% while the Australian Dollar (AUD) was trading at just over 65 US cents.

Last week, share markets continued to fluctuate – albeit on a much smaller scale than previous weeks. While economic data was poor during this time, investors seemed hopeful about the falling number of new daily Coronavirus cases – including in Australia. By Thursday, the ASX 200 gained more than 6% for the week, while the Australian Dollar (AUD) traded at a high of 62.3 US cents.

Daily market play-by-play

TENSIONS FLARE BETWEEN US AND CHINA

In recent weeks, the US and China have engaged in an increasingly bitter war of words over the origin of and responsibility for the Coronavirus. President Trump endorsed the idea that the Coronavirus originated in the Institute of Virology in Wuhan, with Secretary Pompeo publicly declaring that the US had a “mountain of evidence” to support this claim. Naturally, this was not taken well by Chinese state media, who dubbed Pompeo an enemy. Among its many threats, the US reportedly considered revoking China’s “sovereign immunity” which would allow it to be sued for damages in US courts, as well as stopping Chinese students from enrolling in artificial intelligence and quantum computing courses in US universities.


Chinese ambassadors engaged in arguments with other world governments and media outlets over any comments suggesting China was incompetent – including Australia. In response to Prime Minister Morrison’s support for an international inquiry into how China handled the Coronavirus crisis, the Chinese Ambassador to Australia issued a thinly veiled threat suggesting a Chinese consumer boycott of Australian education and wine.


While the world has grown somewhat accustomed to tensions between the US and China, particularly over the last year, the latest dispute comes at a dangerous time given political developments and the fragility of the global economy. As we explore below, both nations face different challenges.
 

CHINA

Since the end of the Cultural Revolution, the Chinese Communist Party’s legitimacy to rule rests on two pillars. The first is strong economic growth, bringing rising income and improved living standards for ordinary Chinese. The second pillar is restoring China to its former glory as Asia’s dominant power before the age of Western Imperialism. President Xi faces difficulties on both fronts. 

 

However, economic growth has declined steadily – from more than 10% per annum in 2007 to around 6% before the Coronavirus crisis (see chart below). This has been driven largely by China’s reluctance to undergo some difficult structural changes – for example, reforming its inefficient state-owned companies and, in particular, the way the large state-owned banks allocate credit to other sectors in the Chinese economy on the basis of political connections. The Coronavirus has also led to negative growth in the March quarter and may lead to lower growth in the future.

Figure 1

Source: Factset

In the face of slower economic growth, President Xi’s leadership style has increasingly relied on appeals to nationalism, which has caused problems and raised concerns for China’s major trading partners. While Xi needs to maintain his strongman image on behalf of generations of angry people eager to teach the West a lesson for any historical slights on China, his aggressive policies for uniting and strengthening the ‘motherland’ have created tension elsewhere – for example, Hong Kong’s pro-democracy protests in 2019 and the controversial 2020 re-election of an openly pro-independence President in Taiwan. This, in turn, has added fuel to the trade war fire and created greater economic uncertainty in China.

 

UNITED STATES

In the US, which is currently the world’s dominant power, there is a broad consensus that China needs to be contained before it grows too strong. However, there are many opinions about such a containment. Some lean toward higher tariffs, a total ban on technology exports to China, and even formal recognition of Taiwan as an independent country. More mainstream opinions seem to favour much milder policies – for example, stricter control over technology exports, more restrictions on Chinese investments, and more assertive support for Taiwan without formal recognition of independence.

 

China is becoming an issue in the upcoming Presidential Election, which could result in both political parties competing to ‘out-hawk’ the other. However, both sides have agreed on one thing: the country’s need to reduce its reliance on China as a supplier – especially for essential medical supplies.

WHAT ARE THE POTENTIAL IMPLICATIONS ON FINANCIAL MARKETS?

Markets dislike uncertainty and volatility – particularly from tensions between the world’s two largest superpowers. While currently overshadowed by the pandemic, this issue will likely rear its ugly head again as the world emerges from lockdown.


The 2018–19 trade war showed that both countries were willing to push the relationship to the edge of the cliff before walking back. Financial markets benefitted from the temporary trade war truce in 2019, with share markets (in particular) delivering strong returns to investors. But this time, a resolution may be more challenging. Longer term, tensions between the US and China could result in lower economic growth for both countries and higher prices for global consumers – potentially having flow-on effects that set financial markets back after a strong year in 2019.

 

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