Options Imply U.S. May Struggle To Win Trade War With China

Summary

• Time may be on the side of China, which could be less inclined to reach a speedy accord to end its long-running trade dispute with the U.S.
• Beijing has a number of countermeasures, including fiscal and monetary stimulus, to help cope with any negative effects from tariffs, options that the U.S. likely lacks.
• China may also stop buying Treasuries, or even sell them to finance fiscal spending, a further potential blow to the U.S.
• Higher tariffs for longer creates headwinds for U.S. equities, something President Donald Trump wants to avoid as he prepares his re-election bid.

By Ashwin Alankar

Chinese President Xi Jinping has more tools at his disposal than his American counterpart, Donald Trump, to deal with the potential negative effects of tariffs, say Myron Scholes and Ash Alankar of the Janus Henderson Adaptive Asset Allocation Team.

U.S. President Donald Trump underestimated Chinese President Xi Jinping's resolve when he raised tariffs on about $200 billion of imports from China to 25% from 10%, warning his counterpart not to respond in kind. That advice was ignored.

Trump's action and China's response - imposing duties on about $60 billion of U.S. exports to take the total of affected products to $110 billion - led to a 2.41% slide in the S&P 500® Index on May 13, its biggest drop since Jan. 3. In combination with a drop in the yield on 10-year Treasuries to about their lowest since 2017, the clear conclusion is that investors are nervous about the impact that the latest tit-for-tat salvos in the long-running trade dispute will have on U.S. economic growth.

Investors are right to be nervous. Even though tariffs hurt China more, due to its $379 billion trade surplus with the U.S. in 2018, it doesn't necessarily mean Beijing is hamstrung. It may actually be able to ride out the storm longer than many think.

Options Favor Chinese Equities

Options prices, which can provide important insights into shifting near-term market risks, suggest that Trump may have picked a fight he has a diminishing chance of winning. For the S&P 500 and other U.S. equities, the ratio of the expected upside (as implied by call options prices) over the expected downside (gleaned from put prices) has declined sharply in recent days. As a result, U.S. equities are among the least attractive of all developed market stocks and less attractive than both Shanghai Stock Exchange A Shares and Hong Kong Stock Exchange H Shares.

From the start of the month through May 10, the upside to downside ratio declined by 5.5% percent to 0.98 and 0.96, respectively, for both A Shares and the Hang Seng (which includes a significant proportion of H Shares). Over the same period, the ratio for the S&P 500 slid 13% to 0.89.

In other words, in recent weeks, options market prices have shifted and now indicate that market participants' consensus view is that Chinese equities are a potentially better buy than U.S. stocks.

This may be partly because China has several countermeasures available to help offset any damage from the trade battle that the U.S. lacks. Moreover, if Xi is politically motivated not to accede to U.S. demands, it could mean China may drag its feet in reaching a deal because the costs to defer might be quite low. Rather, the urgency may be on U.S. officials, because Trump is laser-focused on an immovable deadline: the 2020 U.S. presidential election.

Fiscal, Monetary Weapons

China has the option to employ fiscal stimulus to help overcome the potential economic drag caused by trade tariffs. Bloomberg News reported May 16 that China's central and local authorities have $3.65 trillion in unspent budget - the equivalent of Germany's entire annual economic output - to unleash on public projects if needed. A large spending campaign would be a short-term boost to the second-biggest economy. Such stimulus is virtually impossible in the U.S. as a way to contain any short-term fallout from tariffs because, in addition to taking a long time to undertake such programs, it is unlikely that the Democrat-controlled House of Representatives will sanction further spending on infrastructure projects on concern that it would benefit Trump's re-election bid.

It's a not dissimilar picture on the monetary policy front. As New York Federal Reserve Bank President John Williams said on May 14, tariffs are inflationary, something that is exacerbated when the opposing currency, the yuan, doesn't freely trade, meaning it won't decline to fully adjust for the tariffs (although it has weakened since the trade dispute began). When combined with generationally low U.S. unemployment, such inflationary risk limits the Federal Reserve's (Fed) ability to offset the impact of duties through monetary easing. Despite persistent pressure from Trump to lower rates, the Fed recently reiterated that it will continue to take a patient, data-driven approach to assessing inflation risks.

China doesn't face such limitations. U.S. exports to China rank third behind Japan and South Korea, meaning American imports have less influence on Chinese inflation than goods moving in the other direction. That gives the People's Bank of China more scope to run with monetary stimulus in addition to fiscal spending.

Weaponizing Treasuries

In his bid for a second term, Trump wants to be seen as the guy who brought China to book for long-standing unfair trade practices such as intellectual property theft and the forced sharing of technology. He also needs the S&P 500 to continue to rise. Unfortunately, those two goals may be incompatible. By escalating the trade dispute, Trump looks tough to his base, but he also creates headwinds for U.S. stocks.

China knows this. Beijing can prolong the trade battle, perhaps making it more likely that the U.S. will eventually be the one making concessions. Under this scenario, patience is a virtue for China. In addition to its monetary and fiscal weapons, China may also want - or need - to lower its purchases and holdings of U.S. Treasuries to finance its stimulus program. That would be an additional blow to the U.S., hindering its ability to finance its debt and consumption.

The upside to a long battle with China is that it makes it increasingly unlikely that Trump will risk extending his trade spats to partners in other blocs, as he implied he might do recently via tweets threatening tariffs on European automakers. This is consistent with options signals showing greater upside potential than downside risk for equities in large export economies such as Europe and Japan.

So while on the surface higher tariffs on more goods for a longer period may hurt China more than the U.S. in the short term, it shouldn't be a surprise if the trade battle rages on or, over the long run, China ultimately outguns the U.S.

Reproduced here with permission and under license from Bloomberg. First published on 5/20/19 here.

C-0519-24077 05-30-20

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