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What A Prolonged Trade Conflict Means For China And The World

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by: Alpha Source
Summary

After a stellar first quarter, markets will have to digest an inconvenient reality.

The Chinese economy is far more vulnerable than investors seem to realize.

As economic clarity evaporates and global trade enters unchartered waters, it is important to establish the necessary strategic realignments to mitigate emerging risks.

In recent weeks, it has become abundantly clear that the path of the global economy will depend on the outcome of the ongoing trade standoff between China and the United States. Investors are finally starting to grasp the implications of a full-blown trade war, an event previously considered a low-probability tail risk. With both sides appearing surprisingly recalcitrant as of late, it is crucial to understand who is more vulnerable amid this unfolding war of attrition. This will be a vital component in assessing how markets will react should an agreement remain elusive.

President Donald Trump may be miscalculating the actual cost the U.S. economy will have to bear in the absence of a timely trade deal, but he is convinced that the consequences China will have to suffer will be far more debilitating. Let’s not forget that the second-largest economy in the world is currently in a notably fragile state, and as such a protracted trade war with the United States would dramatically impede it efforts to surpass the U.S. economy, which is still on a far firmer footing.

For all its progress throughout the 21st century, China remains a developing country, which is struggling to avoid the middle-income trap. Undoubtedly, the Chinese economy sorely needs decisive steps in introducing the structural reforms required to tackle to the challenges that lie ahead. In that sense, it can ill-afford to become entangled in a morass of trade friction with its top trading partner.

China’s Major Trading Partners

China

Source: Trading Economics

For more than two decades, Chinese leaders have drawn major support from globalization. In fact, China has been one of the primary beneficiaries of a dramatically more interconnected world. Without open global markets and free trade, achieving such economic success would have been nigh impossible. Yet, this is in the process of changing, as a result of ever-increasing tariffs on Chinese imports. Meanwhile, Chinese tech companies' access to U.S. markets is being drastically reduced, while U.S. companies are forced to implement far-reaching supply chain adjustments to limit Chinese exposure. In essence, a key driving force of China’s economic miracle is gradually fading, which in itself poses a threat to financial stability and economic growth, which may soon reverberate across global markets, if not addressed in a timely fashion.

Indeed, the Chinese economy is in an unusually difficult position, with mounting household debt that could spiral into a major crisis if external conditions deteriorate further. While the corporate sector is also facing a problematic backdrop, the pace of leverage increase in the household sector has reached unsustainable levels, creating critical systemic risk, especially in the face of a prolonged trade war with the United States, which will inevitably deal significant economic damage.

China Debt 2019

Nonetheless, the impact on growth and consumption dynamics of household debt is far from straightforward. There are many who still believe that current levels are manageable, acknowledging, however, that the sudden surge in household debt could erode financial stability. The rapid rise in mortgage loans in combination with an overheated housing market cast a shadow over China’s property sector, which has become the most important store of wealth domestically. This may well be the canary in the coal mine, and Chinese authorities will have to be nimble and vigilant enough to ease macroprudential policy when home prices nosedive. It goes without saying that trade shocks can only aggravate this situation, and President Trump is ostensibly trying to capitalize on this glaring vulnerability of the Chinese economy.

After a first quarter of stellar returns and subdued volatility, markets are finally starting to digest an inconvenient reality. As the Sino-American trade clash escalates, the prospects for corporate profitability will increasingly dim and the clarity as relates to the path of the global economy will dwindle. In this environment, formulating the right investment strategy can be quite challenging, as the set of parameters you have to take into account becomes more fluid and blurry.

Relying on the conflicting signals regarding the progress of the endlessly tortuous trade negotiations has repeatedly proven to be a fool’s errand, and the lack of recent historical experience further obfuscates the task of estimating the aftermath of a full-scale trade conflict between the world's two major economic powers. Consequently, shedding risk, increasing diversification and adopting a more flexible portfolio structure can help --at least in part-- mitigate the looming risks, on the basis of a possible paradigm-shift where capital preservation becomes the primary goal.

Shanghai Stock Exchange Composite Index - May 2019

It is also crucial to understand that the Chinese government will only be able to successfully navigate this complex situation if it abstains from excessive monetary stimulus --the effectiveness of which is steadily waning-- in favor of more fiscal measures, oriented toward redefining the Chinese growth model. If implemented wisely, such measures could help tackle the chronic problem of declining efficiency and productivity among major, state-owned Chinese companies due to resource misallocation.

On a similar vein, the recently imposed Huawei restrictions illustrate how the lingering trade friction between U.S. and China is in reality a symptom not only of economic rivalry but more importantly of deep-rooted national security concerns. The growing rift, congealed by the intractable adjustments made by producers and consumers following the Huawei restrictions, will delay and complicate further a trade deal.

It is evident that China's desire for global dominance is such, that making sufficient concessions to reach a deal with the United States is unlikely in the near future. Therefore, the best it can hope for at this point is a durable cease-fire, which could allow the implementation of all necessary reforms to shield its economy, and subsequently financial markets, from intensifying trade headwinds.

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.