More than a trade war

Rising tension between Washington and Beijing has coloured geopolitics over the past two years. As it intensifies, it will affect financial markets too.

Developed and emerging economies have been impacted. From LatAm to the EU, from Africa to Japan, and all in between, nations are caught between a (big) rock and a (very) hard place. Mike Pompeo’s visit to discuss Huawei with Theresa May proved this point. He wasn’t here to build bridges with the UK. He was here on Trump’s orders to erode UK bridges with China.

But this isn’t just about Trump. His focus on rewarding his political base has led to a broader discussion around America’s place in the world. When it comes to defence, the environment and trade, the US has probably been bailing out other countries for too long.

And it’s not just about trade. More worrying is a growing hostility towards China’s inexorable rise. A tariff war and pressure being heaped on Huawei could be construed as an attempt to cool China’s economy and block its path to global dominance. That’s what it feels like in Beijing.

Trump sticks to his guns…

Trump has been complaining about the trade imbalance with China since before he took office. And the trade deficit continues to grow, hitting a record high of $891 billion at the end of 2018. To manage the deficit, Trump has delivered on a promise to impose tariffs on billions of dollars of Chinese products. Beijing has retaliated and, whilst optimism grew last year that an accord could be reached, Trump more than doubled tariffs this year on $200bn more Chinese products.

Washington and Beijing insist that negotiations are ongoing. Trump will meet Chinese president, Xi Jinping, next month at the G20 in Japan, but the chance of a resolution seems distant, especially given that this trade war feels like the start of something bigger and more pervasive.

…but China holds many aces

With an election looming, markets are more significant for Trump than they are for Beijing. China has already responded by imposing $110 billion worth of tariffs on US goods and they have qualitative measures at their disposal too. The Communist party’s control of the CNY/USD exchange rate and the banks could be a problem for Trump who will base his reelection campaign on economic strengths (jobs and growth), which have been excellent thus far during his tenure. But if Beijing acts, and markets turn, he may be the one seeking compromise.

Recent tariffs caused little pain in US markets, which are all up on the year. This may encourage Trump to take a tougher line, and he’s already threatened a further $325 billion of tariffs. But unless a deal is reached soon, the US economy will feel the tariffs filter through, which act as a stealth tax for US consumers. Effects are already being felt, acutely in the US auto industry, agriculture, even Hollywood, and inflation is nudging up. It’s also estimated that the current levels of tariffs will cost every US household $628 a year, and that impact could test Trump’s supporter base. Hence, there’s been short term market jitters, as investors realise that, if pushed, China has the power to impede US growth, even to the detriment of their own economy.

Despite short term volatility, it will be interesting to see whether the trade war will lead to financial market fragmentation. China’s full integration with the international capital markets has been keenly anticipated, but, if tensions continue and volatility picks up further, this could slow.

More than a trade war

Despite our obsession with Twitter and rolling news, it’s worth remembering that trade wars are fought over many years. This war is not just about the price of soybeans or nefarious phone companies. It’s the latest episode of a war that’s been fought by superpowers through centuries for global superiority.

It’s that sense of magnitude that could spook market participants. Bloomberg concludes that if tariffs expand to cover all US and Chinese trade, global GDP could shrink by $600 billion, with China and US economies shrinking by 0.5% and 0.2% respectively, relative to a no-trade-war scenario. As mentioned, there’s an argument that, despite a stronger contraction, the Chinese would see this outcome as a success so it’s unlikely that they’re going to blink first.

Tariffs – if they continue at similar levels or rise – would also impact economies beyond China and the US. The likes of Taiwan, South Korea and Malaysia are all embedded within Asia’s export supply chain and they would be negatively affected. Of course, countries are also heavily dependent on US exports to China, with Canada and Mexico topping the list. Make no mistake – this is a global trade war with far-reaching implications for economies and markets.

Until now, China’s integration into global capital markets was in the offing, but it’s at risk as long as the geopolitical shenanigans continue. Issuers, dealers and investors hope for a resolution. Short term volatility is manageable, but it feels like we’re standing at the top of a slippery slope – one that could start a more serious and damaging clash of civilisations.