When President Donald Trump ratcheted up his anti-China rhetoric last week, most market watchers expected China to retaliate in kind. But few expected Beijing to be quite so aggressive.
On Aug. 4, the Chinese government allowed the renminbi, its internationally traded currency, to drift below 7 per dollar for the first time since the 1990s, an action seen by many China watchers as an unprecedented escalation. It represents a clear escalation in the trade conflict and, importantly, is a signal that China will not bend to President Trump's latest ratcheting up of tariff rhetoric.
Testing American economic strength
The U.S. economy is increasingly fragile. That observation may sound odd to a casual observer, who could cite the continued economic expansion and the stock market’s long-running bull market as evidence of continuing strength. A look beneath the surface, however, reveals a different situation.
The clearest sign of economic weakness is the recent action by the Federal Reserve to shore up market confidence. Chairman Jerome Powell announced the first interest rate cut since 2008, signaling there are profound concerns about the state of the economy. Yet with interest rates extremely low already, the Fed has extremely limited firepower left to prop up the economy. A prolonged or escalating trade war could end up dragging the U.S. down, perhaps even precipitating a full-blown recession.
Economic consequences may spread
The economic consequences for the U.S. could be significant, especially for industries with exposure to the Chinese market and extended international supply chains. Companies in the semiconductor, aerospace and auto industries are among those facing the brunt of the pressure from the reaction selloff, but the impacts will resonate throughout the economy if the escalation continues. While Ford (F, Financial), General Motors (GM, Financial) and Boeing (BA, Financial) all slipped Monday, their woes could be the tip of the iceberg for U.S. (and global) capital markets.
Beijing's additional admonition of domestic companies from American agricultural products will also be problematic; the grain market has been in turmoil for months, and a boycott would only increase pessimism. It may also represent the start of a broader push to shut out American products.
All of these intense headwinds could help tip the economy, which has managed to continue chugging along in spite of trade war headwinds thus far, into recession.
China plays presidential politics
Overall, China has more to lose than the U.S. in a protracted trade war, a fact of which President Xi Jinping and his advisors are no doubt aware. But Xi also knows that the 2020 presidential election is on the horizon.
Putting pressure on the U.S. economy and presenting a willingness to dig in for a long fight could hamper Trump's chances of re-election. That makes short-term escalation a potentially winning strategy for Beijing, which can use trade war escalation to undermine Trump in hopes of a more conciliatory replacement post-election. Hence, it is unsurprising that Moody’s now believes there is little hope of a meaningful trade deal being struck anytime this year.
Playing hardball is a comparatively low-risk strategy for Beijing since Xi can always dial back his rhetoric and soften his posture in the event that Trump is re-elected.
Verdict
This is a very challenging time for investors everywhere. Few companies can be truly insulated from the fallout of a trade war escalation. With no end in sight, investors should consider adopting more defensive postures.
Trade carefully!
Disclosure: No positions.
Read more here:
- Beyond Meat: Let the Dumping Begin
- No One Wants to Pop the Asset Bubble
- Ray Dalio Says the Fed Is Almost Out of Firepower
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