Tuesday, July 7, 2020

Trump Vs. China – What Should Investors Expect?

NBHM Research Team

US-China relations might sour again soon. How will this impact the financial markets? What should investors know to make informed decisions?

 

US-China trade relations are of huge importance to the global economy. This includes strategic international supply chains, cost of basic goods and overall economic growth. After a prolonged 18-month trade war, the two countries signed the Phase 1 agreement on January 15, 2020. Trade tensions between the US and China had cost the global economy significantly by then.

In August 2019, the US Congressional Budget Office (CBO) had estimated that US tariffs on Chinese goods, along with goods of other countries, would reduce real US GDP by 0.3% and real private investment by 1.3%. Globally, foreign direct investment slowed, with countries like Germany, Britain, Japan and Canada showing severe weakness in manufacturing performance.

While the global economy took a breather with the phase-I deal in January 2020, it was soon hit by the devastating effects of the COVID-19 pandemic. The repercussions of the viral outbreak have been tremendous on the global economy. In its June 2020 World Economic Outlook update, the IMF predicts global GDP growth of 4.9% for the year.

While the pandemic still rages on, there are hints of severe deterioration in US-China relations. This could be an added stress for the financial markets. As of July 6, 2020, the United States, for the first time in 6 years, made a significant show of military might in the South China Sea, a highly disputed region. There are plenty of reasons to believe that matters could get worse.

 

Much Room for Re-Escalation in Tensions

According to the phase-I deal, China has agreed to purchase an additional $200 billion worth of US goods over the next two years, as compared to 2017. However, the pandemic has shattered the Chinese economy and the purchase of US goods has declined 23.5% from the 2019 levels.

It was more than $20 billion short of its promised purchases in Q1 2020. The biggest shortfall has been in US energy products, due to low demand. To make up for it, China has to buy $2.9 billion of energy per month from the US, from April to December 2020, which looks unrealistic, given the current conditions.

Economists are not very optimistic of a phase-II deal being signed anytime soon. There are all possibilities of continued tariff threats, which could stunt global economic recovery, post COVID-19. Many other issues also stand in the way.

For starters, President Trump has been playing a blame game with China, for its gross mishandling of the coronavirus spread in the early months of 2020. The US has gone on to take tough stances against China in several areas, including technology and financial markets. For instance, in May 2020, legislation passed by the US Senate threatened to delist over 200 Chinese companies from US stock exchanges.

The autonomy of Hong Kong has also been a bone of contention. Washington has started to withdraw the city’s “special status” under US law, due to Beijing’s new national security law enacted in Hong Kong, which enables China to tighten its control over the territory.

Now, China’s Belt and Road Initiative and claims over territories in the South China Sea could feed its tensions with the US.

 

Implications for the Financial Markets

 

1. Risk for the Global Equity Markets

According to Goldman Sachs, rise in tensions between the two big countries is a “renewed risk” for the markets. The markets could see a surge in volatility, with additional grim news, such as a fresh surge in coronavirus cases in the US, China and Europe. On July 4, 2020, Spain issued orders for a lockdown of a county of 200,000 people due to a sudden jump in the number of infections.

Stocks globally saw a weekly decline in mid-May 2020, after a prolonged rally, due to the rising concerns over the US-China tensions. But, since then, the markets have been surging, backed by positive investor sentiment concerning the ongoing policy support against the COVID-19 led slowdown.

However, analysts maintain that underneath the surface, the market is beginning to price in the concerns over escalating trade tensions. Retaliatory tariffs or policies issued by China could significantly hurt the US economy. If China shuts out US companies from doing business within its territories, it could be a serious blow to developed market equities. Investors could shift to US Treasuries, raising prices beyond the historical highs and yield below the extremely low levels currently.

 

2. The Tussle Over Hong Kong Will Impact Global Companies

There would be further implications if President Trump revokes Hong Kong’s preferential trading status with the US. Foreign companies will no longer see any benefits of being based in Hong Kong. Many Chinese companies won’t be able to raise funds (mostly in US Dollars), by using Hong Kong as the intermediary.

 

3. A Threat to Crude Oil Demand

Another market sector that could be impacted is the global benchmark oil prices. Optimism regarding renewed demand for crude could take a hit, due to the strained relations between the US and China, pushing oil prices lower. Something similar happened on June 1, 2020, when West Texas Intermediate lost 0.1%, when President Trump said that he would end the special status assigned to Hong Kong under US law.

 

4. Collateral Damage to Other Economies

Investors should also consider the impact of the fallout for other economies, such as Australia. The goods and services sector of Australia is highly dependent on China, with the latter being Australia’s largest export partner in both these sectors. In a hostile trade environment, demand for Australia’s iron ore for the Chinese steel sector will come under pressure. The pandemic has already sapped demand in the Australian education and tourism industry, which ranks third among its whole export mix. Chinese visitors and students spend a lot in the Australian economy. It will be a while before demand goes back to the pre-pandemic levels.

However, Chinese economic recovery has been faster than that of other countries. Asian stocks, particularly Chinese equities, have been resilient. As per emerging market fund managers, average allocation to China was up 35% in April 2020, from a year earlier, according to Morningstar.

Large technology companies have been exploring secondary listings in Hong Kong. US exchanges might push back against proposed delisting regulations by the US Senate, out of fear of losing business. According to experts, Hong Kong is likely to remain a major financial hub, even if in a diminished way, especially if companies are unable to get financing from the US capital markets.

However, destabilised relations between the two major economies could spark significant volatility in the markets, considering that the pandemic is far from over.

 

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