US-China trade talks continue, but new tariffs take effect, hurting investors’ risk appetite
The US increased tariffs to 25% (from 10% previously) on $200bn worth of Chinese goods imports, on last Friday, following no decisive progress on trade discussions. Recall that the US already imposes a 25% levy on $50bn worth of Chinese imports (that mostly include capital and intermediary goods). Importantly, the office of the USTR announced it will begin formal procedures to examine new tariffs on an additional $300bn worth of imports. The latter, if materialized, would mostly hit US consumer products manufactured in China and shipped back to the US, potentially weakening US private consumption.
China retaliated on Monday, by raising tariffs (to 5%-25% from 5%-10%) on circa $60bn worth of US goods, which will come into effect from June 1st. Overall, China has imposed tariffs on about $110bn worth of US products out of total imports of circa $120bn. Vice Premier Liu suggested some points in the negotiations might be harder to agree to (e.g. IP, tech transfer).
Markets reacted negatively to the news of additional tariffs, with global equities declining by 2.6% wow (MSCI ACWI) and by -1.9% on Monday. Corporate bond spreads widened (USD Speculative Grade: +29bps to 401), while safe-haven assets rallied (10Yr USTs: -6bps to 2.47%). However, negotiations continued in Washington in the past week, signaling the willingness of both sides to avoid an all-out trade war.
We outline three possible scenarios for global growth, based on various trade outcomes. The first, and the most favorable, outcome would be an early trade agreement (reports suggest President Trump could meet with President Xi at the G20 summit in Japan, June 28-29). However, even such an outcome would not immediately result in the reversal of tariffs (implemented so far). Nevertheless, global real GDP growth would remain close to trend and the fundamental backdrop for equities would remain supportive (see page 3 for S&P500 EPS revisions turning positive for the first time since December 2018), alongside the dovish turn by central banks.
The second outcome could be a gradual escalation in trade tensions, similar to 2018, with China responding in a “tit-for-tat” manner. As the margin for imposing new tariffs appears limited, Chinese officials could seek to support growth instead (e.g. additional stimulus or a lower yuan FX rate). Less probable options include the reduction of UST holdings (circa $1.1 tn or 7% outstanding of marketable US Government securities) or the backtracking from promised product purchases (US soybeans). A prolonged period of uncertainty (despite the potential for compromise down the road) poses significant downside risks to global GDP growth and risk appetite.
The third (but least likely) outcome could be an increase in tariffs by both sides and/or other outright aggressive measures that would hurt global growth and risk a recession. Policy responses could include monetary and/or fiscal easing to offset the negative impact of a trade war, while growth prospects would be damaged further, since most economic projections currently do not incorporate an increase in tariffs. Some estimates (IMF, October 2018) suggest world GDP growth could decline by almost 0.4 pps in the long run in the event of a full-blown trade war. Investors will rush to safe haven assets (JPY – see page 3 Graph 3), with core Government bond yields likely to slide even further.