The US-China trade war and its impact on financial markets

What is a trade war?

A trade war occurs when one country imposes protectionist trade barriers against another country and the other country retaliates by doing the same. Some barriers include creating import tariffs or placing restrictions on a country’s imports, such as import quotas.

What is a tariff and what do tariffs do?

A tariff is a tax imposed by one country on imported goods and services from foreign countries. The imposition of tariffs is a form of trade protectionism, as they restrict the quantity of imports and increase their retail prices, making them less attractive to domestic consumers.

Aside from raising revenue from increasing the price of foreign goods and services, tariffs also protect domestic industries from foreign competition, which can in turn boost local employment rates.

There are two main types of tariffs, such as a specific tariff and an ad-valorem tariff. A specific tariff is a fixed fee based on the type of imported item, such as a US $1,500 tariff on a car. An ad-valorem tariff is levied based on the imported item’s value, such as 15% of the value of a kitchen appliance.

Why do trade wars happen?

Trade wars can take place if one country perceives another has unfair trading practices or sees them as a threat to domestic businesses. Such a threat can grow out of the presence of a large trade deficit a country has with its trading partner.

A trade deficit occurs when a country finds its imports exceeding its exports in a given time period. A trade deficit is also referred to as a negative balance of trade, and it is calculated for several categories of transactions, such as goods and services.

The lead-up to the US-China trade war

In 2018, the US trade deficit with China was US $419 billion, due to the high number of Chinese imports such as apparel, computers, and other electronics. Much of these products were designed by US companies, but they were counted as imports as they were manufactured and assembled in China.

At the beginning of the year, the US also accused China of unfair trading practices and wanted to pursue a crackdown of Chinese businesses, and there was a strong national desire to revive American manufacturing.

Key tariffs introduced in 2018

To decrease the appeal of Chinese goods, President Trump initiated a handful of tariffs to combat China. These included the global tariff on solar panels and washing machines, tariffs on steel and aluminium, and finally, tariffs on Chinese imports.

Tariffs on solar panels and washing machines

In late January, a 20% tariff was imposed on the first 1.2 million imported large residential washers in the first year, and a 50% tariff on machines above that number. The tariffs declined to 16% and 40% respectively in the third year. For imported solar cells and modules, a 30% tariff was imposed in the first year, which will decline to 15% by the fourth year. 2.5 gigawatts of unassembled solar cells can be imported tariff-free each year. China is the global leading solar equipment manufacturer.

Tariffs on steel and aluminium

In March, the Trump administration concluded metal imports were a threat to national security due to unfair trading practices. A 25% tariff on all steel imports and a 10% tariff on all aluminium imports was announced on 1 March and imposed on 23 March.

Over the years, China had consistently been the number one steel and aluminium producer globally. In 2018, China produced 920 million metric tonnes of crude steel and exports hit record level. Aluminium production also reached its peak that year, with 35.802 million tonnes produced. It was evident that the Chinese economy was developing rapidly, and many predicted it would become the world’s strongest in the coming decade. Many speculated the new policy was pushed to specifically combat China and Chinese goods. However, it played out differently in reality.

At the time, the US had stopped importing steel and aluminium from China as a result of duties imposed by earlier administrations. Thus, these tariffs were largely imposed on Canada, Mexico, Brazil, and other countries. The European Union, Canada, China, Russia, and other countries filed complaints with the World Trade Organization and threatened retaliation, and the US agreed to exempt a handful of countries, excluding China.

Tariffs on Chinese goods

Shortly after that policy blunder, President Trump ordered an investigation into US $60 billion worth of Chinese goods, citing China’s unfair trading practices as the cause for concern. In early April, the US threatened a 25% tariff on over 1,300 categories of Chinese imports, including batteries, satellites, flat-panel televisions, medical devices, and aircraft parts.

Retaliation from China

China retaliated almost immediately, with the Ministry of Commerce of China announcing tariffs on 128 US-imported products. These included a 25% tariff on aluminium, cars, pork, and soybeans, and a 15% tariff on fruit, nuts, and steel piping.

Further retaliation occurred in May, when unnamed foreign buyers, widely believed to be China, cancelled almost 950,000 tonnes of US soybean orders, replacing them with orders from Brazil, the world’s second largest soybean exporter, just behind the US.

In the same month, while China agreed to cut tariffs on US auto imports from 25% to 15%, the US announced it would restrict Chinese acquisition of US technology, citing China was stealing US intellectual property. The US also threatened to target US $50 billion of Chinese imports.

The US-China trade war

In July, widely known as when the US-China trade war officially began, US tariffs went into effect for US $34 billion of Chinese imports. China retaliated by raising tariffs on US auto imports to 40% and confirmed tariffs on US agricultural exports.

The US then announced 10% tariffs on another US $200 billion of Chinese imports to be in effect in mid-September, and it threatened implementing 25% tariffs on a variety of consumer goods, such as fish, handbags, apparel, and furniture, in 2019. In response, China threatened to add tariffs on US $60 billion in US exports, to which President Trump announced the threat of bolstering tariffs until all US $500 billion of Chinese imports are affected.

In August, the US announced a 25% tariff on another US $16 billion worth of Chinese goods to be in effect from 23 August. This tariff applied to industrial equipment such as chemicals, plastic tubes, tractors, and more. In response, China announced a 25% tariff on US $16 billion worth of US goods applied to coal and autos which went into effect the same day.

A month later, the trade war continued to escalate. On 18 September, the US announced a 10% tariff on US $200 billion worth of Chinese imports to be in effect on 24 September. The tariff was to increase to 25% on 1 January the next year, and it affected over 5,000 items, from electronics and food to houseware and tools.

On 1 December, after negotiations, the US agreed to delay the 25% tariff increase from 1 January 2019 to 1 March, and China committed to reinstating substantial purchases of soybeans and other imports. On 13 December, it was reported that China had purchased 1.1 million metric tonnes of soybeans. However, as 2018 came to an end, the US was finding a new focus: Chinese technology theft and the indictment of Chinese hackers.

The impact of the US-China trade war on financial markets

US-China trades suffered, economic growth worldwide slowed amid the trade war, and these effects were felt in financial markets. All in all, it has been estimated by economists that the US-China trade war cost the world up to US $7 trillion in losses.

Global equities

After two years of steady growth, global equities faced some steep challenges in 2018. President Trump’s tax cuts had provided a boost for investors in late 2017. However, the escalation of the US-China trade war created concerns that took a toll on investor

confidence. Most notably, each tariff announcement was associated with stock market decline.

On 1 March 2018, immediately after the US revealed plans of global steel and aluminium tariffs, the stock market tumbled. Investors pulled out in fear of a potential trade war between some of the world’s largest economies. By day’s close, the Dow had dropped 420 points, with manufacturers that use steel and aluminium such as Boeing and General Motors experiencing the sharpest plunges in share prices.

These losses continued the next day. When President Trump tweeted early in the morning, ‘Trade wars are good and easy to win’, the early trading session saw the Dow fall nearly 400 points.

Global equities were in shambles for the remainder of 2018. Investors continued to dump stocks out of fear of an economic slowdown, while Brexit uncertainties in the UK, and unresolved trade negotiations between China and the US added to the pressure. In the last three months of the year, the Chicago Board Options Exchange Volatility Index (VIX) hit its highest level since February at 25.2%.

Stocks fell most sharply in Q4 when the US announced a 10% tariff on over US $200 billion worth of Chinese goods. This included autos, which ended up being one of the worst performing sectors of 2018, alongside other ‘cyclical sectors’ such as banking, where demand is typically dependent on the overall health of the economy.

By the end of the year, both the Dow and the S&P 500 had experienced their biggest annual losses since the financial crisis in 2008. The Dow was down 5.2% and the S&P was down 6.2%. The NASDAQ Composite also experienced its worst year in a decade, losing 3.9% and a six-year winning streak.

Bonds

Tariffs, by nature, are inflationary as they ultimately increase the price of foreign goods, allowing domestic producers to increase prices as well. Tariffs imposed by the US resulted in an uptick in US bond yields in March and April based on the rise in the US Fed funds rate and inflation. By mid-May, the yield on the benchmark 10-year US Treasury note had risen to 3.11%, and this significant 3% yield remained until the end of the year when risk aversion returned.

Commodities

In 2018, the commodities market received a significant shake in April when China announced the 25% retaliatory tariff on US soybean exports.

Soybeans had always been one of the top agriculture exports from the US with Brazil following closely behind, and Chinese buyers made up a substantial share of total world consumption of soybeans. In the coming months, soybean premiums at Brazilian ports soared.

When orders were shifted to Brazil in May, a trade disruption drove a wedge into the world soybean market and lowered US prices while increasing Brazilian prices. By June, most-active soybean futures on the Chicago Board of Trade had sunk 14%. The

price of Brazil soybean premium soared from its January price of around US $0.50 per bushel to over US $2.00 in the second half of 2018 during harvest season.

US and Brazilian soybean prices returned to their previous relative levels in December. This was due to adjustments made to the trade network and improved market sentiment at potential cooling off-of trade war tensions. However, commodities, rocked by a tumultuous year, did not make a speedy recovery and ended the year down 15.3%.

Gold

Meanwhile, the gold price kicked off the year trading in a fairly tight range in the first quarter. It declined sharply from April to August by 15% from US $1,365 to US $1,160 due to higher equity prices and strong GDP figures. However, as equity markets were hit with extreme volatility in the final months of the year, investors flocked to gold once again and gained 10% from August to December. Despite this, gold prices ended the year down 1.1%.

Forex

In the first months of 2018, the forex market experienced high trading volumes. The dollar had weakened in late 2017, and investors were eagerly awaiting changes. Tariffs imposed by the US and trade tensions slowed growth in China and Europe, while complications from the Brexit referendum caused the Pound sterling to slip. Combined with a steady rise of interest rates from the Federal Reserve and domestic spending increases, the US dollar strengthened.

Momentum also made a strong case for more gains. With positive investor sentiment, 2018 ended with a 4.7% YoY increase for the US dollar. The only other major currency to record a gain was the Japanese Yen, which rose more than 2%.

Cryptocurrency

Cryptocurrency is a highly speculative asset that diverges from traditional regularised systems within financial markets. Driven by uncertainties in the stock market from the US-China trade war and general enthusiasm from previous years, there was substantial increase in trading volume. However, in 2018, a cryptocurrency crash early on in the year left the market crippled and unable to recover. By year’s end, Bitcoin prices dropped more than 77% from its opening price of US $13,062 in January and many other cryptocurrencies also had their worst performing 12-month stretch ever.

Takeaway for investors

The US-China trade war had far-reaching effects in every market, emphasising the importance of diversification within portfolios and even within asset classes. No stocks are immune to equity market volatility. However, investing in companies that tend to derive a larger proportion of their revenues domestically may lower risk during a trade war. At the same time, hedging with commodities remain a good, traditional option. Investors can also look at investing in volatility ETFs in times of great market uncertainty, as these funds tend to move in the opposite direction of the broad market.

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