The rising US-China conflict

Private Debt Boutique

KATCHING OPPORTUNITIES

We focus on senior secured direct lending strategies with short durations that offer stable and attractive returns, protection and liquidity.

Katch Investment Group logo

Until recently, 2019 was a great relief for investors. Equity indices recovered, reaching new highs after the sharp correction at the end of last year. Economic news has not been excellent, but strong enough to dispel recession fears. The corporate sector in the US published good results, avoiding the feared earnings recession in the first quarter. Finally, the USA and China were extremely close to reaching a trade agreement that might have alleviated the remaining uncertainties and eventually would have pushed retail investors to join the Wall Street party.

But then the unexpected happened again. On Sunday, May 5th, President Donald Trump issued two tweets that threatened to increase the current 10% tariff for $200B on Chinese imports to 25% as of Friday, May 10th. In addition, he threatened to impose a 25% tariff on all remaining imports from China. This measure was completely unexpected, since US government officials, including Treasury Secretary Steven Mnuchin and Trade Representative Robert Lighthizer, were saying that the agreement was almost done.

As a result, the S&P 500 posted its biggest weekly loss since last year’s major correction and for a brief moment, investors’ nerves were tested again.

What was the reason for Trump’s U-turn? According to different press reports, on Friday, May 3rd, US negotiators received revised terms from China, reversing the prior acceptance of several aspects of the agreement. Apparently, there were disagreements regarding subsidies, data transfer restrictions, rules for foreign cloud computing companies and the approval of genetically modified seeds, among other things. There were also disagreements on how the agreement was going to be published. The US wanted every word in the agreement to be made public, while China just wanted to publish a summary.

It is not clear why China suddenly changed its position. Maybe it was just a miscalculation to think that the US would accept the new terms to be able to finalize the agreement quickly. But the opposite happened. With his tweets, Trump counterattacked and made it very clear that he does not accept the last minute revisions. Additionally, on Wednesday, May 15th, the Trump administration announced measures in which it effectively bans the Chinese company Huawei from selling technology in the US market, and could also prevent it from buying Qualcomm’s semiconductors, which are crucial for their production. This strategy could paralyze China’s largest technology company, depress the business of US chip giants and potentially disrupt the deployment of critical 5G wireless networks around the world. And of course, these measures are likely to heighten fears in Beijing that Trump’s broader goal could be to contain China’s power and technological advance.

Trump tried to calm the markets saying he still hopes to reach an agreement with Chinese President Xi Jinping when the two meet at the G20 summit to be held on June 28thand 29thin Osaka. There are still reasons to be optimistic. An absolute trade war would impact both countries in a very negative way. The corporate sector or consumers would have to “pay” for the tariff costs. This could cause margin pressures for companies and potentially consumer price inflation. According to a study by Oxford Economics, tariffs of 25% for all Chinese imports and a retaliation by China would reduce US GDP growth by 0.5%, and China’s GDP growth by 1.3%. However, the side effects on business and consumer confidence, as well as supply chain disruptions, could cause a global recession in 2020.

This certainly is not the intention of President Trump. In fact, he repeatedly linked the performance of his administration with the performance of the US stock market, as well as other economic indicators, especially the strong jobs creation during his term. It would not be prudent to kill the economy just before entering the campaign for his re-election, scheduled for Tuesday, November 3rd, 2020.

Most likely, we will have an agreement sooner or later. The negotiations will continue to be tough and there are likely to be more confrontations and delays. That will cause volatility in the financial markets. However, stock markets are unlikely to fall back to the December lows, mainly because we have a more favorable monetary policy. The Federal Reserve stopped raising rates and showed some flexibility in cutting rates if necessary.

Also, China has room to stimulate the economy and has done so by cutting taxes. Economists at Deutsche Bank estimate that this year’s fiscal stimulus will amount to approximately Rmb 500-600B, equivalent to intensify 0.5% of GDP, and if necessary, China could increase this stimulus. That could help to offset the damage caused by the trade war and keep economic growth above 6%.

For now, the outlook for financial markets remains relatively positive. However, it is also true that the recent escalation related to national security, such as the controversy around Huawei, indicates that the current trade conflicts are unquestionably just an opening shot in a much wider conflict between the United States and China, which is expected to intensify in the coming years.

Performance of the S&P 500 Index

Source: Bloomberg