Why America Wins The Trade War And How Clever Stock Traders Can Profit From It

|
Includes: BA, DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, HUSV, IVV, IWL, IWM, JHML, JKD, OTPIX, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWM, RYARX, RYRSX, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, UWM, VFINX, VOO, VTWO, VV
by: Avery Goodman

Summary

The USA holds all the cards in any trade war with China, and the Chinese will be forced to capitulate to Trump's demands.

US equities are already unrealistically overpriced, but after an initial decline, they will become even more overpriced, as money continues to flow into US from the collapsing eurozone.

For clever traders, extremely profitable "windows of opportunity" are on the way.

Recently, the American stock market, along with other stock markets around the world, has been falling. The panic has been sparked by fears over the effect of a trade war between the USA and other nations, particularly China. While some markets outside the United States, particularly in China, are falling for good reason, the same is not true for those in the USA. This situation, as usual under such circumstances, will provide clever market participants who are willing to take risk, the opportunity to make money from volatility.

The problems began on June 15, 2018, when the Trump administration slapped a 25% tariff on $50 billion worth of Chinese goods regularly imported into the United States. Not to be outdone, the very next day, June 16, 2018, China announced a retaliatory 25% tariff on $50 billion worth of American exports to China. The news is filled with stories that say we are embarking on a "trade war" that cannot be won and which will cripple both economies. And markets dropped like a stone.

According to so-called "experts", quoted in media like Business Insider, China is specifically "targeting" Trump voters in rural states by increasing tariffs on coal, oil, and food ranging from asparagus to frozen trout and chicken wings. A closer look, however, tells a different story. The simple truth is that the Chinese do not have a large selection of goods to choose from. For example, China is also imposing tariffs on American lobsters, even though the vast majority of lobsters come from ultra-liberal coastal New England, which certainly did not vote for President Trump.

China exports about $500 billion per year to America, but imports only about $130 billion from America. Mostly, China imports raw materials. Here's the breakdown for 2017 based on data from the US Congressional Research Service, as compiled by Statistica.

If China is to retaliate at all, it must do so on the type of goods it imports. There are no others to choose from. While China does import things like highly sophisticated semiconductors from the USA, imposing tariffs on those would cripple China's exports worldwide. Their consumer goods manufacturers are heavily dependent upon them. That's why they haven't been included in the retaliatory tariffs list. Aside from that, the total value of all electronic integrated circuits amounts to about $6 billion, a proverbial "drop in the bucket".

The crippling effect of a cutoff of the flow of semiconductors was illustrated when the Chinese manufacturer, ZTE, was sanctioned by the US Commerce Department. American semiconductor manufacturers were prohibited from selling parts to ZTE. The Chinese phone maker was forced to close its assembly lines and faced bankruptcy as a result. The punitive action was eventually "commuted" by the US administration, during the process of the trade negotiations when President Trump himself intervened and was converted into a $1 billion fine. However, on June 18, 2018, the US Senate voting 85 to 10 (a veto-proof majority) voted in favor of a bill nixing the deal. In other words, ZTE may end up out-of-business after all.

The point is clear. Absent a sudden turn toward masochism, China cannot afford to impose tariffs on things like American semiconductors. Additional measures could be taken against American headquartered manufacturing companies like Ford (F) and GM (GM) that are building things inside China. But that would stifle the flow of technology from America and conflicts with fundamental Chinese government policy. Airplane orders, mostly from Boeing Corporation (NYSE:BA) could be added to the tariff list. But adding Boeing planes to the mix would cause China's national airlines to suffer a competitive disadvantage against other airlines. Boeing builds certain specialized planes, like the 787, against which its bungling competitor, Airbus (OTCPK:EADSY), has no competitive offering.

President Trump recently threatened to slap an additional $200 billion in tariffs against Chinese products. Let's say the Chinese want to retaliate again. There are only $80 billion worth of additional American imports to attack, including imports like semiconductors, the lack of which would destroy China's own industries. In spite of this obvious reality, mainstream economists claim that the use of tariffs will hurt both parties equally and cannot work as a negotiating tool.

They ignore two key points. First, that American commodities (the primary American products bought by the Chinese) are identical to commodities produced elsewhere. It doesn't matter whether they come from the USA or Brazil. A soybean is always a soybean! Other than the differential cost of transportation from different locations, commodity prices are the same worldwide. The Chinese do not buy American soybeans because they love the USA. They buy them because they need to eat.

Non-US soybean producers will have fewer soybeans left to sell to the rest of the world. So, the non-Chinese buyers will have to turn to other sources. Where will they turn? The answer is simple. They will buy soybeans from the USA. America will have the excess beans because of the loss of Chinese customers, but non-American producers will have excess customers who will be forced to turn to America to fill their needs. All soybeans will be selling for slightly higher prices worldwide, as a result of the Chinese tariffs because non-American producers will face less competition and will raise their prices, affecting prices everywhere. After a short adjustment period, not only will American farmers be selling the same number of soybeans but will be selling them more profitably. The same is true with respect to each and every commodity upon which the Chinese have imposed a retaliatory tariff.

In the medium term, once adjustments are made, American producers will make more money from selling the same number of goods at a slightly higher world price. Consumers all over the world, but especially in China, will pay the price. The "price" to the American consumer will be high, but it will be more than offset by the fact that American tariffs will make it economically possible for American manufacturing to compete with China. In contrast, the price to Chinese industry will be astronomical because their products end up more expensive, there is no substitute for the American market, and American imposed tariffs will create new competitors in the USA and elsewhere.

If tariffs stay on long enough, especially if extended to other ultra-low-cost nations, the gains to America's collective "purse" may outweigh losses caused by the increase in consumer prices, as its hollowed out industries recover. In contrast, the Chinese gain absolutely nothing from retaliatory tariffs. It doesn't matter how long they maintain them, whether they are extended to other western nations or to more products. The cost to China of imposing tariffs upon commodities will have no offsetting benefits. That's because it is impossible to shift commodity production to China. It already produces all the commodities it can produce. The rest must be imported, and it doesn't matter where they come from. It's as simple as that.

All of this having been said, US Commerce Secretary Wilbur Ross has already made it clear that he believes that the U.S. "will end up negotiating these things rather than fighting over them." The key issue for negotiation, however, is not the $370 billion trade gap. More importantly, the Trump administration is trying to deter China from continuing to force western companies to give up trade secrets and technology. According to the Council for Foreign Relations, the Chinese government initiative known as "Made in China 2025" calls for achieving 'self-sufficiency' through technology substitution while becoming a "manufacturing superpower" that dominates the global market in critical high-tech industries. Specifically, it stated:

Equally problematic to Beijing's goal of "self-sufficiency" and becoming a "manufacturing superpower" is how it plans to achieve it. Chinese officials know that China lags behind in critical hi-tech sectors and hence are pushing a strategy of promoting foreign acquisitions, forced technology transfer agreements, and, in many cases, commercial cyber espionage to gain cutting-edge technologies and know-how.

While the Obama administration spent years pressuring Beijing to rein in commercial cyber espionage, Washington and other capitals are only beginning to grapple with the repercussions of Chinese investment and technology transfer agreements. Unlike cyber theft, neither is illegal per se. Surging Chinese investment in the United States and Europe have been a recurring story over the past few years. However, lawmakers are increasingly concerned that such investments, especially in high-tech sectors, are not just a product of market forces, but guided by Beijing as well."

"Made in China 2025" is a problem for the USA and other western nations because it threatens their economies and their fundamental security. The West maintains military superiority in large part because of technological superiority. With China aggressively pursuing its national policy of forcing western companies to transfer technology to Chinese companies, technological superiority will evaporate. The USA cannot afford to continue sitting idly by letting that happen. China cannot be allowed to continue forcing its companies to give up technology simply to access the Chinese market.

The current trade negotiations are the last chance to redress these problems before the tables are turned. Mr. Trump is playing his hand smartly because he knows the USA still holds all the Aces, and China is playing a weak hand. That won't continue if nothing is done. China's ongoing policies are intended to and will reverse the situation. The Chinese must be forced to the negotiating table now even if it means dragging them there. Tariffs are part of the process. China's leaders will eventually realize that they cannot win the trade battle against a determined American opponent.

A considerable number of back and forth statements and actions can be expected over the next few months. That is likely to rile the stock market causing price declines. In the end, Trump will get what he wants. Most important to note is that American stocks will continue to be vastly overvalued even after a drop of 20-25% or, perhaps, even more. However, the overvaluation, large though it is, doesn't matter. The euro currency will inevitably cease to exist, and European money managers know it. There is a vast pool of capital in Europe, and it is being systematically shifted into the perceived safe haven of American assets. Now that the Federal Reserve is finished printing money (at least for the moment), capital flows from Europe are a large part of the reason stock prices have not fallen. Once the issue of trade war with China has passed, prices will rise again.

In other words, American stock prices are bound to get even more bloated than they are now before they eventually crash and burn. The dip that is caused by trade war is a buying opportunity that will allow fast profits. When China accedes to US demands, the flow of European money will resume, and American stock prices should return to their bloated condition and more.

It is important to make it clear that bloated equity prices are probably not a permanent situation. A nominal collapse of American stocks may be prevented simply by Federal Reserve money printing along with some market manipulation by its primary dealers. However, the collapse of real equity values to more realistic levels is inevitable in the long term.

Once the euro nations either reach the unlikely agreement to be jointly liable for each other's debt or when the euro experiment ends, viable national currencies will be restored. International money flows will reverse. Money will flow out of the American stock market and back to Europe. US stock prices will return to normality, at least in real terms. That's why traders must be not only ready to buy but also to sell when the time comes.

A willingness to engage in short- and medium-term trading is a matter of investment style and risk appetite. Long-term investors who are looking for 10-20 year value investments should steer clear. The strategy I am about to outline comes with significant risks. First, the US Federal Reserve may badly mistime its tightening regime. Raising interest rates is mandatory if it wants to prevent the implosion of America's underfunded pension funds. However, if it is done too quickly, it could cause a monetary implosion that foreign money cannot overcome. Second, the problem of the euro may remain unsolved for so long that European institutions become complacent. That might cut money flows into perceived "safe havens" like American equities. Third, stock prices may already be so high and inherently unstable that small changes in international capital flows could cause them to change faster than the average medium-term trader can react.

Having said all that, those willing to accept these risks should eventually see some very good opportunities. It's important to stay tuned to developments from week to week. The important buying and selling windows on the way could easily be missed. The timeline is unclear. Logic tells us that prices will continue to drop for an indeterminate amount of time, as China vigorously fights its losing battle against the Trump administration, but how deeply those price drops are and when they occur will depend upon the actions each nation takes in response to the other.

Back and forth warnings and threats are likely to ramp up. That should cause American stocks to lose some of their safe haven appeal for Europeans. If I were forced to give an estimate, I'd say that falling prices should create buying opportunities within 3-12 months. Once China capitulates, stock prices should temporarily resume their buoyancy and soar to heights even more unrealistic than they are now, as the money flow resumes.

So, what, where, and when to buy and sell? It all depends on what happens over the next few months. For example, will China shoot itself in the foot by adding taxes to the purchase of Boeing airplanes? We don't know yet. Answers must wait until the scenario further unfolds.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.