Trade war will probably not end in Armageddon, but investors should be wary

Aidan Yao says that, ultimately, the consequences of a trade war between Washington and Beijing would be so severe that we can expect both countries to back down. In the meantime, however, expect disruptions

PUBLISHED : Wednesday, 11 April, 2018, 3:18pm
UPDATED : Wednesday, 11 April, 2018, 10:30pm

Despite having the best macro backdrop since the financial crisis, the global equity market has come under significant selling pressure of late, as escalating fears of a trade war cast a cloud over solid economic fundamentals.

The fluid situation, created by constantly changing rhetoric and multiple voices from both sides, has made the outlook of Sino-US economic relations very uncertain, leaving the market to reassess the risk of the Armageddon scenario of all-out trade war.

To be frank, we, like the market, have been caught off guard by how fast the situation has deteriorated over the past month.

Not only did the US conclude the Section 301 investigation – on China’s transfer of US technology – way ahead of schedule, leading to punitive tariffs of US$60 billion on Chinese imports, but Beijing also responded quickly with retaliation of equal scale, targeting 106 American products, including soybeans and cars, for a 25 per cent levy.

The degree of hostility ratcheted up to unprecedented levels within a very short period, leaving the market concerned that confrontations between the world’s two largest economies will deal a lethal blow to the global recovery.

Knowing what is at stake, one can only assume that trade policies are no longer viewed as pure economic issues, but a tool to reap political gains.

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This is clear on Trump’s side. Trade protectionism, piggybacked on his “America first” policy, was a winning card on his way to the White House. Now, as the midterm elections draw near and with Trump still unpopular, he is playing that card again to revive support from his base.

Politics matters on China’s side too. President Xi Jinping is now widely viewed as the strongest Chinese leader in decades after extensive power consolidation in his first term. With that position and status, Xi does not want to be seen as weak, by both his internal and external audience, in succumbing to Donald Trump’s escalating pressure and conceding defeat in a trade war.

In addition, the latest tariffs imposed on China’s tech and aerospace products are seen as a deliberate attempt by the US to undermine Beijing’s “Made in China 2025” strategy, orchestrated by Xi to make China a global power in innovation in the coming decades.

Disgusted by the US’ containment of China, some officials and pundits in Beijing have vowed to fight tooth and nail to protect China’s rights and future.

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These political entanglements in what one might consider a purely economic issue have complicated the situation and made predicting the future all the more difficult.

For what is worth, it’s still assumed that the two sides will come to their senses and work something out to avoid trade Armageddon. Not only does it make perfect economic sense, but the political case for a deal is strong, too.

In the US, voices of concern over the adverse impact of a trade war have ratcheted up, and will only get louder, in our view, as the White House starts consultation with the different industries on the proposed measures.

These have already started to strike a conciliatory tone among some US officials, with both US Trade Representative Robert Lighthizer and Trump’s chief economic adviser, Larry Kudlow, recently stressing that the tariffs are just proposals at this stage and the US still prefers to negotiate a deal rather than enter a war.

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Overall, a trade war makes no economic or political sense for Trump or Xi.

Despite being sanguine on the eventual outcome, however, the path to that final destination is likely to be bumpy. Trump’s tactic of exerting maximum pressure on his opponents ahead of negotiation – consistent with his “art of the deal” strategy – is now being countered by similar tactics from Xi, suggesting Trump has met his match.

With hostile exchanges possibly continuing, the global markets will be in for a rough ride until a final outcome is reached.

Large corrections in equities and other assets could send negative feedback through the global economy, more serious than the direct shock from trade tariffs. Rising market volatility could also interrupt the path of policy normalisation by the US Federal Reserve and other central banks.

Investors need to take note of these risks, and properly protect their portfolio before the cloud of uncertainty clears.

Aidan Yao is senior emerging Asia economist at AXA Investment Managers