The market was clearly taken by surprise when President Donald Trump made it clear that a trade deal might not come together. Now, strategists and economists are scrambling to revisit the possible fallout for the global economy and markets if talks break down and the situation escalates into a trade war.
Despite the Dow Jones Industrial Average’s nearly 500-point drop on Tuesday, most strategists remain hopeful for some sort of trade resolution. (Both the Dow and the S&P 500 were back in the green on Wednesday morning.) But even the optimists acknowledge the risks of talks falling apart have risen—and the potential downside is greater given the expectations that the two sides would make nice. But if the two sides strike a trade deal—even an imperfect one—the near-term boost to U.S. and Chinese stocks could be greater than anticipated just a couple of weeks ago, given this week’s scare.
But Bank of America Merrill Lynch’s China and Asia economist Helen Qiaotold clients in a note Tuesday her base case is a trade impasse. The urgency for a deal may have faded a bit amid better economic growth and strong market performance in both countries this year, Qiao writes. “Even if the tariff hike doesn’t materialize this week, the two sides could exchange harsh rhetoric on each other in the media and suspend official trade negotiations for a month or two, before returning to the negotiation table formally in the following quarters.”
The result: Volatility continues and companies stop spending until they get more clarity on trade.
Sadly, that is the optimistic outlook. The pessimistic one is a collapse into tit-for-tat skirmishes, with the U.S. implementing new tariffs and China retaliating, possibly with hikes on U.S.-made cars—and escalating from there. Volatility and concerns about growth in China, inflation in the U.S., and global growth more broadly would follow, Qiao writes. The silver lining: The Chinese economy has more of a buffer now as its stimulus over the past year hashelped growth bottom out.
UBS economist Tao Wang writes that a 25% additional tariff on Chinese exports could lead to a 2 percentage point drag on China’s economic growth over the next 12 months. While China’s exports and its economy have already felt some of that pain, Wang estimates it would take an additional 1.2 percentage points to 1.5 percentage points hit if an all-out trade war ensued. The pain is milder—about 0.3 to half a percentage point haircut to growth in the next 12 months—if the U.S. hikes tariffs on the $200 billion of Chinese goods from 10% to 25% without imposing fresh tariffs
A full-on trade war would likely mean China’s economic growth dips below 6%.To cushion that blow, the Chinese could increase stimulus. China already cut reserve requirements for small rural commercial banks. But Wang expects the government to increase stimulus, shifting toward an easing stance and even investing in infrastructure and cutting reserve requirement ratios for banks further in the event of an escalation.
For investors a trade escalation would play out on several fronts. The dollar could strengthen against major currencies—though its gains may be limited. That’s because the greenback is more expensive now than it was in the fourth quarter, and investors have recently begun been betting on its rise, writes UBS strategist Daniel Waldman in a separate note on Tuesday. The Chinese yuan, which was one of the most sensitive to the threat of new tariffs this week, could break the symbolically important dollar/yuan level of 7.0 if tensions were to rise significantly, Waldman writes.
Global stocks could drop another 9% if the trade war continues to escalate, Waldman says, using the fourth quarter reaction to tensions as its gauge. Strong growth in the U.S., Chinese stimulus and a supportive Federal Reserve should limit near-term downside, especially as earnings expectations have already been lowered. European markets like Germany’s DAX and U.S. cyclical sectors like metals and mining and autos have the highest correlation to the performance of trade-impacted stocks—and are among the vulnerable to continued trade tensions.
While he expects the U.S. and China to reach a trade deal, Wolfe Research’s Chris Senyek told investors in a note Tuesday to remain defensively positioned amid the increased trade uncertainty and Federal Reserve Chairman Powell’s recently more hawkish tone. The imposition of the 10% tariff on $200 billion on Chinese imports last September sparked a sharp drop in global trade volumes that resulted in the recent global economic soft patch—a window into what could happen if tariffs are hiked. When to take on more risk? Wait until there is more certainty around the trade outlook and incoming economic data shows signs of a sustained improvement, he writes.
Reshma Kapadia
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