U.S China Trade War - What are the implications from a further escalation in US-China trade tensions?
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What are the implications from a further escalation in US-China trade tensions?

The breakdown in US-China trade talks following the latest round of tariffs in May has reignited the debate surrounding the potential evolution of the conflict between these two global superpowers and the implications for investors. We see three broad potential outcomes: 1) escalation is temporary, leading to a deal by the G20 meeting in late June (28-29); 2) escalation leads to a standoff which persists for a medium time horizon (3-6 months) before reaching a resolution; 3) no-deal scenario, where the US and China impose 25%+ tariffs on all traded goods. While our assessment indicates that the odds for a no-deal scenario have increased significantly, our base case points to scenario 2 as the most likely outcome. Hence, we maintain our positive view on risk assets on a 12-month basis, even as our near-term view advocates for a more cautious stance. Markets have performed better than during the last episode of rising trade tensions Looking at the peak-to-trough reaction of different assets after Trump’s initial twitter threat on 5 May 2019 and now* and comparing it to the performance of these assets after the USD 50bn tariff implementation announcement in June 2018, the market reaction thus far has been more muted , likely helped by the support from easier monetary conditions vis-à-vis last year.

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What is the economic impact of an escalation?

The economic impact of actual (and potential) tariffs could have varying repercussions among the various regions of the world. However, ignoring counterbalancing measures, the negative impact to Chinese GDP growth ranges from as low as 0.2% to as high as 1.7% for the worst-case scenario in the ensuing 12 months. For the US, the measurable impact appears to be smaller (around 0.3% to 1.0%). Despite Trump’s promises of China paying for the tariffs, studies indicate that the next tariffs on USD 325bn of imports may hit US consumers more than in the previous rounds (for more details, refer to macro section. More concerning to investors will be the potential for negative feedback loops from the trade war on business confidence and financial markets, which is less easily quantifiable. It is widely believed additional tariffs will lead to higher inflation in both the US and China. However, prior episodes of trade tariff implementation have shown the impact to be disinflationary rather than inflationary. Trade tensions increase economic policy uncertainty and can undermine business confidence and investment, undermining overall economic activity and inflation expectations. In recent times, this pattern can be seen in declining import volumes, not only for the US and China, but also for Europe where threats of higher auto tariffs have been delayed by another six months. Notwithstanding some regional winners from the trade disruption, it is estimated that global growth could be negatively impacted by 0.3-0.5%.

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What is the impact on financial markets from trade escalation?

Currencies are likely to be the most immediate transmission vehicle, starting with the CNY. Often mentioned as a key part of a possible trade deal, a stable CNY is essential for the sustainability of capital flows (both for equity and bond markets) into China. Weakness in the currency could potentially counter some of the impact from Trump’s tariffs. However, in our base scenario, we believe China’s government is committed to defending the 7.0 level in the near term, higher volatility notwithstanding. Meanwhile, the JPY would likely benefit from any sustained risk-off environment. In terms of equity market implications, China equities (especially the Chinese exporters to the US) could be the most directly hit. Any heightened concerns over the CNY may result in capital outflows, tightening domestic monetary conditions and investors’ willingness to hold Chinese assets. Sectors with sizeable exposure to USD-denominated debt (e.g. Property) could be more significantly impacted from any CNY weakness. Though we acknowledge these risks, we assign a lower probability than our base scenario. The US equity market tends to be more resilient during flare ups in US-China trade tensions (Figure 8). We are watching key technical levels of 2720 and 2650 on the S&P 500 index as medium-term support. At the sector level, the US technology sector could be at a greater risk from Chinese retaliatory measures (post the recent ban by the US on Huawei’s access to US supply chains).

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Markets are concerned about the impact of trade on Asia USD bonds, given 60% of the issuers are from Hong Kong and China. However, we see limited negative impact on Asian USD bonds, given the still stable local demand and limited US exposure (c.2% of issuers).