How U.S.-China trade uncertainty could affect markets

“Markets have swung from euphoria over [U.S.] tax cuts to the protectionism pits.”

So says TD senior economist Leslie Preston in a weekly economics report, referring to last week’s market performance. The poor showing was in response to the U.S. announcement to impose tariffs of 25% on up to US$60 billion of Chinese imports.

Read: Trump exempts close U.S. allies from tariffs

Despite market response, the announcement was hardly a bolt out of the blue.

“For more than a year, I have been busily opining to anyone who would listen that the real issue on the U.S. trade front is with China,” says BMO chief economist Douglas Porter in a weekly financial digest—not with other trade partners, including Canada. That’s because the trade disparity between the U.S. and China is unparalleled.

“China alone accounts for nearly half of the total U.S. trade deficit, and the ratio of exports to imports is seriously imbalanced between the two,” says Porter. “For every dollar of goods that the U.S. exports to China, it brings four dollars of goods back the other way.” In comparison, the ratio with Mexico last year was less than 1.3 to 1.

What investors should know

Of concern for investors, U.S.-China trade uncertainty could dampen synchronized global growth—bad news for business.

In the BMO digest, senior economist Robert Kavcic says that trade rhetoric “takes some shine off a fundamentally strong environment for [U.S.] earnings growth,” which has recently been accelerating because of top-line demand, as opposed to share buybacks and cost cutting.

And, interestingly, Kavcic says that the profit share of GDP has turned higher, after previously falling in classic late-cycle fashion.

“That has helped keep the bull market running,” he says, “but is also very much in the rearview mirror. The question now is how a deepening tightening cycle and a growth dampening/inflation-inducing trade spat work their way through the income statement.”

Read: When the expansion will end—and how to protect portfolios

BMO senior economist Jennifer Lee says in the BMO digest that so far it’s business as usual for central banks: several, including the Fed, moved ahead last week with their plans for monetary policy. “But if talk morphs into serious action on the trade front, the pace of slow and steady normalization will be that much slower,” Lee says.

Read: Outlook for equities as rates rise

China said last week it would retaliate with its own tariffs targeting a relatively modest US$3 billion in U.S. goods.

The subsequent damage to U.S. companies “would not deal a body blow to the over $19 trillion U.S. economy, which looks set to grow quite strongly over the next two years,” says Preston.

On the bright side, struggling trade relations between the U.S. and China could pave the way for smoother NAFTA negotiations.

Says Porter: “With the U.S. dropping the gloves with China on trade, does it really want to spend precious time and resources grappling with its neighbours on a second front? Most likely not, and we suspect the U.S. may be much more open to seriously dealing now.”

Read: Why news of NAFTA progress underwhelms

Market effects

Rather than how proposed tariffs would impact companies’ bottom lines, Preston says of greater concern are the indirect effects of “a more adversarial global trade environment and the uncertainty it breeds that could hamper investment and trigger volatility on financial markets.”

Stocks and the U.S. dollar lagged last week after news of the tariffs, while Treasury yields were stagnant. (Today, stocks were rebounding, as trade war worries eased and as tech companies and banks made gains.)

Porter reminds that “trade wars are not good for bonds, as any hit to growth is washed aside by the upward pressure [trade wars] put on inflation.”

A winner last week was gold—up almost 3%. The metal “thrives on chaos, a weak dollar and inflation,” says Porter.

China-U.S. trade negotiations

For now, it remains unclear when or if U.S. tariffs on Chinese imports will come into effect.

Says Preston: “We have already seen the U.S. walk back the scope of recently announced steel and aluminum tariffs by exempting more countries, suggesting that [last] week’s announcement is an opening gambit.”

Today, China’s government said it’s open to negotiating with Washington amid the spiralling tariff dispute following a news report American officials have submitted a list of market-opening requests.

A foreign ministry spokeswoman, Hua Chunying, didn’t confirm the report by The Wall Street Journal but said at a regular briefing, “Our door for dialogue and discussion is always open.”

China has yet to say how it might respond to Trump’s approval Thursday of possible higher duties on the US$60 billion of Chinese goods.

The Journal said U.S. Treasury Secretary Steven Mnuchin and China’s economic czar, Vice Premier Liu He, were leading negotiations. It said American market-opening requests as a possible condition of a settlement covered the auto, finance and semiconductor industries.

China’s official Xinhua News Agency reported Saturday that Liu and Mnuchin talked by phone but gave no indication they were holding negotiations. Xinhua cited Liu as saying Beijing is “capable of safeguarding its national interests.”

“We are full of confidence and the capability to defend our legitimate and lawful interests under any circumstances,” said Hua. “Now the ball is in the U.S. court, and we hope the United States will make its decision cautiously and reasonably.”

For additional details from the economists, read the full reports from TD and BMO.

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