In brief
• Trade tensions continue to rise between China and the U.S. Little progress was made at the most recent meeting between top economic policymakers in Beijing, meaning investors will have to keep a watchful eye on this issue, which will likely continue to spur market volatility.
• China is pursuing a one-for-one response strategy to U.S. actions, but given the large trade surplus China runs with the U.S., it will soon run out of U.S. products on which to apply equivalent tariffs.
• China’s most powerful weapons to fight a trade war lie beyond tariffs. China could target the sales of U.S. companies, which sell far more goods in China to Chinese consumers than the U.S. exports to the country, while the opposite is true for China. The U.S. actually runs a net surplus with China when measured in terms of total economic revenue-exports of goods and services to and sales of firms in a partner country.
• The impact of rising trade tensions will be felt on the microeconomic level in the U.S. and on the macroeconomic level in China, due to the structure of each country’s economic relationship with the other, making investing under rising trade tensions a more nuanced exercise.
Over the past few months, investors have had to contend with markets that lurch between panic over trade-related headlines and cautious optimism when trade stays out of the headlines. Given the size of the economies involved, their close trade linkages and the fact markets have benefited enormously from globalization, any hint of rising protectionism between the U.S. and China naturally worries investors.
The U.S. administration vows to change the way China does business and to reduce the large trade deficit the U.S. runs with China-the U.S. administration views trade deficits as inherently bad. The U.S. set out to rebalance this relationship by initiating several investigations into China’s conduct, chief among them the Section 301 investigation into the treatment of U.S. companies and their intellectual property in China. These legal avenues set up the U.S.’s first actions squarely targeted at China: tariffs on USD 50 billion, then another USD 100 billion, of Chinese imports. Markets have a negative view on tariffs in general, which, combined with continued harsh rhetoric about China’s corporate behavior, has given investors plenty to worry about.
It is important to remember that talk is not action and to focus on policy changes that have actually been implemented-of which there have been very few. The U.S. government is still seeking public comments before finalizing the products in the first group of imports subject to tariffs. For all the heated rhetoric, the U.S.-China relationship has shifted very little. The most headline grabbing moves by the U.S. have mostly related to preexisting legal disputes. For those able to ignore the rhetoric and focus on the fundamentals, these past few months have still been unnerving as worries over the eventual outcome-and its effect on markets beyond the U.S. and China-remain at the forefront of investors’ minds.
Rebalancing the relationship
At the core of this trade dispute is an argument over economic systems; China does not want to make changes to its state-led economic model, while the U.S. sees state involvement as giving Chinese companies an unfair edge. The list of eight goals U.S. and Chinese policymakers presented each other with during negotiations last week reflect this stumbling block. The U.S. demands China stop subsidizing industries that China hopes will lead its economy in a few years’ time-companies integral to the Made in China 2025 initiative-while China pressed the U.S. for fewer export restrictions on sensitive technologies and for a stop to the constant threat of protectionist measures.
Chinese authorities believe their treatment of foreign companies in China is appropriate, aim to avoid tariffs on Chinese exports and will continue pursuing the Made in China 2025 agenda. The goals of the U.S. are less clear; the U.S.’s requested actions and threats so far seem to either focus on the trade deficit or on China’s economic structure, rather than the treatment of U.S. companies that spurred the U.S.’s first tariffs. The U.S. will be hampered in future negotiations if it approaches them without a clear objective.
Tariffs on Chinese imports may reduce the trade deficit somewhat. Restrictions on investment in the U.S. would slow down China’s development as a strategic competitor. Neither of these tools would push China to change industrial policy domestically in a major way or change its treatment of U.S. firms. Counterproductive to U.S. goals, the U.S. tariff announcement prompted China to retaliate with equivalent tariffs rather than to make concessions on the U.S.’s demands. Each new move by the U.S. has been met with a one-for-one response by China. The U.S. commonly refers to the new economic relationship it hopes to build with China as one of “balanced trade”. If balanced trade is the goal, what does balance look like?
Exports don’t tell the whole story
Exports, which can be discouraged with the use of tariffs and quotas, are only one facet of the economic relationship between the U.S. and China. The U.S. does run a substantial trade deficit with China; that is, the U.S. imports more from China than it exports. Yet, the U.S. runs a net surplus in total economic revenue derived from China. Trade between countries is measured by the value of goods and services that cross a customs border, which leaves a blind spot in the data. Trade statistics are an incomplete way to measure the economic relationship between two countries. In this age of globalization, many American companies manufactureproducts in China for end consumption by Chinese consumers. The value of these sales shows up in companies’ quarterly earnings reports and impacts the stock price of shares traded on American exchanges, but are missing from trade data. When sales of U.S. firms in China and vice versa are taken into account, the U.S. actually ran a USD 45 billion surplus with China in 2015 (Exhibit 1). Looking at the U.S.-China dispute in terms of economic revenue (exports of goods and services to and sales of domestic firms in another country) offers deeper insights into how rising trade tensions could impact markets.

Successful investing relies on looking ahead-positioning oneself to take advantage of market conditions that will materialize versus what the present environment suggests- and the ability to stay the course when weaker nerves fray. In the current environment, an investor needs to think beyond the application of tariffs to the second and third order impacts of a rise in trade tensions. The ripple effects of the U.S.-China trade dispute will be far reaching, but do not necessarily spell doom for global markets. While we do not know how these tensions will be resolved, examining the negotiating objectives of each country gives us some idea of what might end up on the negotiating table besides tariffs.
Thinking beyond tariffs
In the list of negotiating goals presented to Chinese policymakers, U.S. officials insisted on a USD 200 billion reduction of the U.S.-China goods trade deficit by 2021, an amount equal to 53% of the 2017 deficit. The U.S. administration already announced tariffs of 25% on approximately USD 50 billion of Chinese imports and also threatened an additional USD 100 billion of imports with tariffs. China has so far pursued a one-for-one approach-U.S. tariffs on USD 50 billion of imports were met with tariffs on USD 50 billion of U.S. exports to China. As shown in Exhibit 2, if the U.S. proceeds to apply the announced additional tariffs, which would then cover a total USD 150 billion of imports, China will hit a ceiling when it likely moves to do the same. The U.S. does not export USD 150 billion of goods to China. Adding services to the equation brings U.S. exports to China to just over the USD 150 billion mark.

U.S. tariffs on Chinese imports also pose a headwind to its own companies’ earnings, particularly to information technology and industrial firms. Grouping the roughly 1,300 products so far on the U.S.’s published tariff list into sectors, a rough estimate constructed by pairing each product with the Global Industry Classification Standard (GICS) industry most likely to use it, reveals that the vast majority of these tariffs fall on intermediate goods for information technology and industrial companies, illustrated in Exhibit 3. Tariff headwinds will most keenly be felt in U.S. equity margins as these tariffs raise the cost of doing business and companies vary in their ability to pass along higher prices to consumers

Trade actions felt on the micro level in the U.S.,macro in China
If the U.S. administration moves to retaliate with more tariffs on more Chinese imports, China will either have to apply a higher tariff rate or, more likely, turn its focus to reducing the sales of U.S. business in China. This avenue offers China plenty of targets since sales of U.S. companies in China dwarf U.S. exports to China, as depicted in Exhibit 2 on the previous page. Given the Chinese government’s ability to enact new regulations to make it tougher for U.S. firms to operate in China, limiting sales of U.S. firms to the same degree tariffs would have would not be difficult. Though a small share of overall U.S. large cap revenues come from China, exposure is not evenly distributed; information technology, consumer staples and industrial names are most exposed. Sales in China of these three sectors account for around 2.6% (from an admittedly incomplete data set) of total S&P 500 revenues, versus 1.4% for the remaining sectors.
China’s retaliatory tariffs on U.S. goods on their own are unlikely to alter U.S. companies’ operations in China in the short term; reorganizing supply chains takes time and the process is highly dependent on the specific product being produced. However, the rise in tensions, ahead of any concrete actions on trade, is already having an economic impact. Trade has been named in recent months in business surveys as the reason for delaying investments or postponing hiring decisions. Again, the picture differs widely across industries and types of companies, making analyzing the full effect of trade tensions on the U.S. a company by company exercise.
Conversely, the impact on China will likely fall mostly within the macroeconomic realm. Exports are more important to the Chinese economy than they are to the U.S. Exports from China contain components from dozens of countries since China has begun offshoring some of its own production. One of China’s chief economic goals is to be responsible for more of the value-added content in its own exports as it tries to move up the global value chain. However, imbedded content from other markets means that if tariffs bite or some other negotiated solution leads to a reduction in Chinese exports, several other countries could see their exports fall too-most notably Japan, the eurozone, the U.S., Korea and Taiwan (Exhibit 4, next page).

A tariff for a tariff makes the whole world poor To successfully navigate these trade tensions, investors need to keep their focus on the end game. What has been proposed so far is unlikely to resemble the eventual policy change. However, most investors are not content to wait for the ink to dry on some future agreement before making investment decisions. As negotiations progress and trade-related headlines continue to alternate between panic and optimism, markets will seesaw back and forth. In the end, the global economy is likely to look very much like it does now, but conducting business for several U.S. companies will become more difficult and costly. Chinese companies are relatively insulated on the individual level, but a slowdown in exports to the U.S. if tariffs are implemented could contribute to the rollover in economic momentum we currently see in China. For the active investor, these factors suggest an increasing degree of selectivity in the U.S. equity market, a relatively benign outlook for Chinese equities and a potentially larger allocation to emerging markets with smaller contributions to China’s manufacturing sector.

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Published by J.P.Morgan Asset Management. Author: Hannah Anderson. Global Market Strategist

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