Trump is foolish to think China will back down from a trade war

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While I have never been in a real hurricane — I’ve only gotten hit by the remains of several as they moved up the East Coast — they say that the very middle (the “eye”) of the storm is remarkably calm.

Those who have been unfortunate enough to get a direct hit actually get a reprieve in the very middle of the storm, as the weather calms until the back end of the hurricane wall repeats the devastation that the front end just caused. The eye of the storm provides a false sense of security that “it will all work out somehow.”

There is a small possibility that China and the U.S. are impaled simultaneously by going into a full-scale trade war before coming to a resolution.

We survived imploding volatility exchange-traded products in February, and we have now made all-time highs in the Russell 2000 RUT, +0.16%  and the Nasdaq 100 NDX, +0.67%  indexes. The stock market is now remarkably calm as President Trump is cattle-prodding the Chinese with his intentional weeks-long delays on announced tariff packages in order to make a deal, and he just gave them an extra week until Sept. 5. His approach has not worked yet, so we have to consider the scenarios, of which there are three.

Three scenarios

The best-case scenario is for the Chinese, and others in a similar situation, to make a deal before the majority of the announced tariffs go into effect. This scenario seems unlikely, based on the present trajectory of trade negotiations and the move of the Chinese yuan, which is experiencing its steepest decline in many years (seen as a move higher on the inverted chart). The Chinese are taking away the gift they gave the Trump administration in 2017 by guiding the yuan to appreciate (the move lower on the chart). At this rate of depreciation, the USDCNY, +0.2931% exchange rate could breach 7 very soon.

While it is overly simplistic to think that the Chinese are devaluing to simply counter a 25% tariff with a 25% devaluation, this sharp reversal is an indication that the yuan is a major weapon in their arsenal to be used in the current trade negotiation. I still think that even with a tit-for-tat devaluation of the yuan for the size of the tariffs, we will have a disruption in Chinese (and perhaps U.S.) economic activity, as it will be problematic for the investment cycles in both economies as the level of uncertainty remains high.

I know that a $375 billion bilateral trade deficit with China seems like a big number but it is not that large compared with the trade deficit that the U.S. had with the rest of the world as a percentage of gross domestic product (GDP) 10 years ago, when President George W. Bush had a current account deficit as high as 6% of GDP (the biggest component of which was crude oil imports). Trump’s current account deficit is just 2.4% of GDP (see chart).

As to another one of Trump’s claims — that a lot of U.S. factories closed and “the jobs went to China” — the volume of U.S. GDP from manufacturing has never been as high as it is today. In other words, the jobs never left. The problem is that due to globalization and the need to compete, U.S. businesses invested more heavily in manufacturing capacity in China and the service side of the U.S. economy grew faster, while the manufacturing side of the U.S. economy grew at a slower pace. This is Capitalism 101, and someone needs to show Trump those statistics, as some things he said on the campaign trail (and still says today) are demonstrably false (see chart).

I agree that the Chinese have taken advantage of the U.S. in bilateral trade, and that if they want, they could cut the trade deficit between the two countries in half very easily. The Chinese have long used trade as a tool to exert political influence, and therefore they purposefully buy more from their neighbors and key partners than they do from the U.S. This type of clever self-serving behavior needs to stop. Still, the present confrontational course of the trade negotiations is worrisome.

The base case

The base-case scenario is that the cattle-prod delay in tariff implementations will not work, as the Chinese simply will not bow to this kind of pressure, and they will make a deal after global markets begin to roil in August and September (dare I say October) as more and more tariffs actually go into effect, and the yuan gets weaker and weaker as they show the world they are fighting the good fight. That way the Chinese save face, which is how they like to operate. That type of scenario enables the Chinese to continue to exert their influence on their friends and partners.

Finally, as in any sword fight, there is a small possibility that both parties are impaled simultaneously by going into a full-scale trade war before coming to a resolution. That would not be very smart of either the Chinese or Trump, but it is a small possibility we need to consider. In that case, the Chinese yuan gets devalued dramatically, the Federal Reserve stops its quantitative tightening, and the 10-year Treasury TYU8, +0.10%  yield drops to 1% or lower due to the serious deflationary impact of a full-scale trade war and a Chinese devaluation.

Ivan Martchev is an investment strategist at institutional money manager Navellier and Associates. The opinions expressed are solely his own.