Last Thursday, President Donald Trump announced his intent to impose a tariff of 10% on all Chinese goods that have remained unaffected by the previous rounds of tariffs. The new levies, which came against the prevailing recommendations of his advisors, would apply to approximately $300 billion worth of goods effective September 1st. The announcement comes on the heels of the G20 summit in Osaka after discussions between US and Chinese trade representatives stalled. This news had a dampening effect on markets in the United States and China. Equity prices in the United States took a significant dive, with the S&P 500 down nearly 3% on Monday.

The announcement is not necessarily shocking. As the two countries have yet to reach a sweeping deal, many analysts predicted that a lack of progress in Osaka could result in some form of escalation. Following Monday's declines, the S&P 500 is now down nearly 6% from its record high reached on July 26th. We believe that, based on this reaction, the market is not pricing in the likelihood of a resolution. The following are three reasons why we think that the market is underestimating the probability of a near-term deal.

Economics vs. Optics

Nomura Securities estimates that the immediate impact of the new round of tariffs will lead to a 0.2% cut in China's year-over-year GDP growth rate. While this is far from an ideal outcome, the reduction is nominal for an economy with an annual GDP growth rate that hovers around 6%.¹ The new tariffs, should they go into effect, are also expected to result in a 5% decline in Chinese exports to the United States. Meanwhile, exports not previously subjected to tariffs experienced year-over-year growth of 7.7% in May of this year.² Therefore, in the short term, the economic impact of tariffs on China may not be as impactful as headlines portray.

In the United States, on the other hand, the negative impact of the new tariffs may jeopardize their implementation and effectiveness. Compared to previous tariff rounds, the new tariffs could target more imports of consumer goods from China, including mobile phones, tablets, and toys. As such, the new tariffs could directly affect the American consumer. The American public might feel the consequences of these tariffs more directly than prior rounds, leading to an adverse reaction from consumers, companies, and markets. The rapid feedback loop may entice the Administration to strike a deal.

The Nuclear Option was Withheld

Rather than moving to a full 25% tariff, a 10% tariff appears to be a warning shot, or at a minimum, a recognition that the US is more dependent on the consumer goods in this tariff basket. In refraining from moving to 25%, the Administration is indicating a willingness to negotiate, rather than win at any cost.

We believe the president's previous abandonment of a hardline tariff proposal for Mexico shows that tariff announcements do not always result in implementation. At the end of May, President Trump announced that he planned to enact tariffs on Mexico for its failure to address issues of immigration. Only nine days after this statement, the president announced that both sides had achieved a compromise and that tariffs would be called off. As this round of tariffs on China threatens to be nearly as destructive as those proposed for Mexico, they might equally represent a final bargaining chip leading to compromise.

Voters Prefer Bull Markets

This round of proposed tariffs has further proven the direct connection between tariffs and equity prices in the United States, with global equity markets suffering steep one-day declines post-announcement on Monday. While no bull market can go on forever, a prolonged and ineffective trade war can push markets lower. Recent data from Gavekal reveals that US households have over 20% of household assets in equity holdings.³ Despite equities having reached record highs in July, investors have short memories and may vote accordingly if markets experience continued declines. With elections just 15 months away, policy decisions are prone to be judged not only on their merits but also on how they impact markets.

Beijing has already responded firmly to the new round of tariffs. The government ordered state-owned firms to slow all imports of US agricultural products. The realization of such a policy could also lead to economic woes for the US and right at the heart of Trump's political base. It may also be difficult for Beijing to sustain such a policy given their evident need for US agricultural imports. This could help bring Chinese President Xi Jinping and his Administration to the negotiating table as well.

RMB Policy: Yuan to remain strong amid uncertainties

The People's Bank of China (PBOC) has responded to the escalation of tensions with a strategy of targeted easing and loosening of currency controls. On Monday, China's currency, the Renminbi (RMB), breached the psychologically important "7" level to the US dollar. This is an arbitrary threshold set by the PBOC after 2008 meaning the exchange rate will not exceed seven RMB to one dollar. Investors might conclude that this represents an extreme attempt to offset the damage that trade tensions are inflicting on China's economy. However, this strategy comes as China's central bank is in a strong position to pursue easing and allow mild depreciation. Contrary to popular opinion in the US, the central bank's goal is not aggressive devaluation to prop up exports, but to use the tools at its disposal to promote monetary stability in the long term. This behavior is not manipulation, but the realization of an independent monetary policy.

As central banks across the developed world have pursued a policy of prolonged easing, China has kept rates relatively steady over the past few years, with current 10-year government bond rates above 3%.⁴ Global interest rate cuts afford China more maneuvering room in terms of monetary policy. Furthermore, China maintains considerable foreign exchange (FX) reserves that work as an insurance policy against runaway depreciation. China's FX reserves were worth $3.12 trillion in June.

There is overwhelming evidence that the RMB weakens in response to increases in protectionist rhetoric on the part of the United States.⁵ Every announcement of significant escalation in the tariffs has resulted in a weaker RMB. In essence, the RMB is acting as a shock absorber, shielding the Chinese economy from the full impact of tariffs, and therefore limiting their effectiveness.

Increases in US protectionism also result in more monetary accommodation on the part of the PBOC. However, these increases in flexibility are targeted. The PBOC has announced that it will refrain from providing stimulus for the volatile real estate sector, while at the same time decreasing reserve requirements for banks. This policy should result in positive revenue growth for the financial sector.⁶

While the RMB may experience some depreciation in the short term, in the long run, the currency is likely to remain stable. Last night, PBOC governor Yi Gang said: "I am fully confident that the yuan will remain a strong currency in spite of recent fluctuations amid external uncertainties."⁷ Any depreciation may be kept in check by China's strong desire to de-dollarize⁷ its trade and turn the RMB into an FX reserve currency itself. CICC research predicts that while RMB might fall against the dollar, it will remain stable compared to a broader basket of currencies.⁸ Thus, the PBOC is not manipulating the price of the RMB, but rather managing the economy in response to macroeconomic conditions. This parallels the behavior of central banks in nearly every developed economy.

What to watch for next…

All of this comes as earnings remain positive in many industries across China. We expect economic fundamentals and secular trends to remain largely unchanged. China's GDP grew at 6.2% year-over-year in the second quarter of 2019.³ Tencent, Alibaba, and Baidu all release earnings this month on the 14th, 15th, and 19th respectively. Trade talks are expected to resume in Washington in early September and we will be watching them closely. Subscribe to our blog, China Last Night, for our latest China analysis.

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1. Liu, Kevin. “Re-Emerging Uncertainties Weigh on Sentiment.” CICC Research. August 4, 2019.
2. Gave, Louis. “The Renminbi Devaluation’s Fork In The Road.” Gavekal Research. August 5, 2019.
3. Bloomberg Data as of 8/5/2019.
4. Gave, Louis. “The Renminbi Devaluation’s Fork In The Road.” Gavekal Research. August 5, 2019.
5. Liu, Liu. “External uncertainties rise again. Possible additional US tariffs on US$300bn worth of Chinese goods.” CICC Research. August 2, 2019.
6. Gave, Louis. “The Renminbi Devaluation’s Fork In The Road.” Gavekal Research. August 5, 2019.
7. Liu, Liu. “External uncertainties rise again. Possible additional US tariffs on US$300bn worth of Chinese goods.” CICC Research. August 2, 2019.
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