Is the trade war morphing into a new cold war? – Special Report

Marios Hadjikyriacos, XM Investment Research Desk

The trade conflict between Washington and Beijing took a breather lately, after the two camps agreed on some small issues and reached a de-facto truce. Even if this small agreement is finalized in November though, a ‘big’ deal wouldn’t be any closer as neither side is ready to compromise on the real issues. For that to change, a US recession might need to come on the horizon, making Trump soften his stance to boost the economy before the 2020 election. Overall, there’s a growing sense that this trade battle is slowly but surely evolving into a new cold war.  

It’s tremendous

The latest updates on the US-China trade war have been mildly positive. The two sides reached a ‘mini’ deal last week, which would entail China buying greater quantities of US agricultural goods in exchange for Washington cancelling the tariff increases it had planned for this month. Markets cheered in relief, as this was seen as a ceasefire in the protracted trade battle, reducing the risk of further escalation.

President Trump praised this mini deal as “tremendous”, while Chinese state media described it as “of great significance”. In truth though, this accord seems more symbolic than anything else. The uncertainty has started to bite both economies – with the US manufacturing sector coming to its knees and Chinese growth slowing – so the two leaders took some short-term economic relief, agreeing to the bare minimum and kicking the more important issues down the road.

Unintended consequences

Regrettably for Trump, by striking this truce, he might have diminished his chances of getting a ‘big’ deal. Relenting so much pressure means that Beijing gets some valuable breathing space, so the Chinese leadership won’t be in any rush to make concessions on the real issues, like intellectual property protection.

From China’s lens, compromising any further as the US presidential race gets underway might even boost Trump’s reelection chances, by giving him a real ‘victory’ he can present to the electorate. Beijing may have also seen the impeachment process as weakening Trump’s hand.

Even implementing the ‘mini’ deal may not be as straightforward as it looks. Recent reports suggest China will struggle to fulfill its agricultural pledges unless the US rolls back some tariffs – something not part of the agreement. Hence, there’s a real risk the two sides find it difficult to put the details of even this small deal on paper, and that the talks will stall again before the middle of November, when the two leaders are expected to sign it.

From trade war, to cold war?

The bottom line is that ‘mini’ deal or not, reaching a real accord remains as difficult as ever. Rather, the conflict between the two superpowers seems to be expanding beyond trade, branching out into the realms of geopolitics, technology, and finance – increasingly resembling a new cold war.

On the geopolitical board, the US has taken a confrontational stance on every issue, ranging from freedom of navigation operations in the South China Sea, to selling arms to Taiwan, to supporting the pro-democracy protests in Hong Kong most recently. Naturally, Beijing is furious with these interferences. It considers them infringements on its sovereignty, and recently threatened “strong countermeasures” if the US supports the Hong Kong protests.

On the tech front, the mere word “Huawei” is enough to get the message across. The US has almost banned the Chinese tech giant from doing business in America, and lately, the Trump administration also blacklisted several Chinese artificial intelligence firms for playing a part in human rights violations.

The financial dimension has yet to play out, but media reports suggest the US is considering delisting Chinese companies from US exchanges and instructing state pension funds to limit their investments to China. That could be the next step once Trump runs out of Chinese products to slap tariffs on.

New normal?

Granted, all these may simply be posturing by the US aimed at extracting bigger concessions on trade. Trump himself said that Huawei could be part of any trade deal. However, there’s a sense that this is a broader shift on the global chessboard, like a containment strategy towards China, rather than a mere restructuring of the trading relationship.

Adding credence to this, is the bipartisan nature of ‘China antagonism’ in the US. Both Republicans and Democrats largely share the view that the US must preserve its competitive edge, with leading Democratic presidential candidates such as Warren and Sanders calling for “economic patriotism” and for protecting American workers from unfair competition.

The point is, even if Trump loses next year’s election, there’s no guarantee that US-China relations will go back to normal – far from it actually. In fact, a recent survey of fund managers by Bank of America Merill Lynch showed some 43% of respondents believing that the trade war will not be resolved, and that this situation is the ‘new normal’.

More pain needed for Trump to give in

Hence, a final deal looks extremely unlikely anytime soon. Even assuming everything goes smoothly with the ‘mini’ deal in November, the second phase of the negotiations – which will focus on intellectual property and industrial subsidies – is an uphill battle. These are the most important issues for US negotiators, and China feels it has already conceded as much as it can without compromising its sovereignty. If substantial progress isn’t made in the next weeks, another round of US tariffs is still scheduled for December.

What would it take to turn the tide? Admittedly, the most important variable for reaching a final deal might be the 2020 election, and how the US economy performs heading into that. To put it bluntly: if trade tensions hurt growth enough to seriously threaten a recession, then Trump might soften his demands and take any deal that’s on the table, even one that lacks substance. Make no mistake, the President’s number one priority is getting reelected, and a recession – especially one caused by his trade war – won’t help him with that.

In other words, unless a downturn is on the horizon, Trump is unlikely to feel much need to compromise.

Market impact

Turning to the markets, the mood has turned more optimistic lately on the back of the ‘mini’ deal, and of course an improving Brexit atmosphere. Safe-haven currencies like the Japanese yen have surrendered much of their gains, while US stock markets have recovered a lot of ground and are back within breathing distance of their all-time highs.

That said, these moves don’t seem like a reversal in the broader ‘risk-off’ trend, but a mere correction instead. The trade war could heat up again, and the macroeconomic environment is still very weak, especially in Europe.

This implies that the yen may come back under demand before long, not only due to its haven appeal, but also due to interest rate differentials narrowing in its favor. The Bank of Japan has very limited firepower to ease policy any further, while the Fed for example can still cut rates a few more times if the situation worsens.

However, a major retreat in stock markets may need something much bigger to manifest. Central bank stimulus typically supports equities, so for stocks to really drop, we would probably need to reach the stage where investors no longer think that monetary easing can protect the economy from a recession.