It seems as if every single day brings a new headline about the ongoing trade dispute between the United States and China. Instigated by President Donald Trump in the early days of his administration, bombastic rhetoric gradually morphed into action. Tariffs rose, businesses faltered, and China retaliated. By most accounts, we are now embroiled in a full-blown trade war.
It was thus quite intriguing to come across an article trending on Seeking Alpha titled “The Trade War Is Over, We Won.” The article’s author, Herve van Caloen, contends that China’s leaders, having grievously miscalculated the extent of Trump’s resolve, allowed themselves to get sucked into a tit-for-tat trade war they were not prepared to fight - or capable of winning. But van Caloen is not satisfied with the conclusion that America has the upper hand in the current conflict; indeed, he is emphatic in his stance that the United States has already won.
Is this conclusion correct? We would contend that the political and economic conditions in both superpowers are much different, and the conflict far more fraught. Indeed, the trade war is far from over, and there is no guarantee that we will win. If anything, China may now have the upper hand. The continuation of the trade war will continue to inject uncertainty in financial markets. A resolution, even marginally in China's favor, could well lead to a return to relative normalcy.
Let’s discuss Caloen’s arguments, the trade war, and what we can expect from the back-half of the Trump administration.
Presidential Containment Breach
Van Caloen’s argument begins with a discussion of the so-called “Iron Triangle,” a concept devised by Milton Friedman, a Nobel Prize-winning economist of the market-oriented Chicago School. This triangle, like every triangle, has three sides. In this case, the sides consist of:
- special interest groups
- regulators and bureaucrats
According to Friedman, these three groups tend to share an interest in maintaining the status quo and thus will work, separately or in concert, to stymie any effort to reform the system.
The “Iron Triangle” is meant to offer a basic model of institutional behavior in response to external efforts to alter a status quo. While perhaps overly simplistic, it does provide a fairly solid explanation of how reformist leaders can enter office (or come to lead another large institution) with great zeal, only to be ground to a halt within months.
Van Caloen makes use of the “Iron Triangle” concept in an attempt to explain the behavior of China’s leaders, especially President Xi Jinping:
“It looks as if Xi Jinping was a good student of Milton Friedman. He thought that if he waited a bit, the Trump administration would cave in. The Iron Triangle, he bought, would soon convince the president to give up his trade crusade. All the Chinese would have to do is increase imports of soy beans and the Americans would claim a victory and back off.”
According to this reading of the situation, Xi believed Trump’s bluster would fade as the normal institutions of US government bent their most unusual commander-in-chief into a more conventional form. In other words, the opposition to trade conflict shared in common by the federal bureaucracy, Republican and Democratic establishments, and privileged business interests, would combine to halt Trump’s major break from conventional diplomacy.
So far, it is hard to call this view wrong. Indeed, it is quite accurate to point out that Trump has proven to be a far harder force to contain than established power centers once believed. Trump’s unwillingness to bend may have left the Chinese on the back foot. Where China expected a swift resolution via American capitulation, instead they found iron resolve and a willingness to escalate the tit-for-tat tariff increases that have affected a host of products, from steel to microchips to cars.
China has been caught up in an escalating trade war it did not think it would have to fight. Meanwhile, the Trump administration has continued to ratchet up pressure in an effort to get China to make a number of concessions, covering everything from raw material dumping to intellectual property theft.
The unexpected intensification of the conflict has sent severe ripples across international markets. Uncertainty is generally bad for trade.
The Long Game
China’s vaunted reputation for patience and for “playing the long game” may not amount to as much as some observers believe in the case of the present trade conflict, a point van Caloen makes succinctly:
The problem for China is that for once they do not have time on their side. How often have we heard that the Chinese can sit it out? Chinese people are considered to think long term. American democracy is not equipped to fight a trade war. The stock market and business people cannot take a slowdown. An economic downturn would bring the administration down etc. This is what the talking heads have been saying. Yet, it looks as if this time China is the one blinking first.”
On this point, we agree - up to a point. Indeed, the tendency shared by a vast swathe of American politicians, academics, and media figures to treat the Chinese psyche as some kind of oriental monolith has always seemed rather distasteful. However, that does not mean that China is in any hurry to capitulate to American demands.
In a trade war between two states so economically interwoven as are the United States and China, both sides will inevitably suffer from the effects of tariffs, sanctions, and other retaliatory measures.
Companies with exposure to international commerce have thus taken a beating, though not as bad as those companies directly impacted by tariffs on either side of the divide. Investors must pay close attention to developments, since escalation could crush markets, while a resolution would almost certainly trigger an upward surge.
So here is the big question: Which side can suffer through the pain for longer?
China, wracked by economic weakness and political fragility, might arguably be in the more perilous position, meaning it will have to bend first. Perhaps China cannot afford to keep the trade war going. A weak economy, and fear of the instability it could engender, should bring China to heel, according to the pro-American view.
Alas, American victory in the trade war is no fait accompli. The trade war is far from over - and Chinese defeat is far from certain. If it drags on, or intensifies, investors will suffer on both sides (and in markets around the world). Any sign of serious escalation, or of either side digging in its heels for a knock-down drag-out fight, investors would be wise to consider looking for safe-harbor investments to see them through the storm.
The Republic vs. the People’s Republic
Political and economic realities rarely show the courtesy of conforming to models. There are always outliers, and Donald Trump is unquestionably one of them. But the Trump administration is still constrained by fundamental institutional forces, forces that include (but are not limited to) the denizens of the “Iron Triangle.” As a nation of laws and deeply-ingrained institutional processes and norms, the policy of the United States cannot be bent to the will of a single man, no matter how much he wills it.
During his first two years in office, Trump faced pushback from within his own party to such an extent that, despite ostensibly having control of the White House and both Houses of Congress, many of his early policy priorities languished or died. Things will be even harder now. A new Congress has just been elected and the Democrats now control the House of Representatives. While the lower chamber holds limited sway over foreign policy decision-making, its ability to stymie legislation is a potent weapon indeed.
Faced with a divided Congress, a woeful approval rating, and a punishing re-election campaign, the back-half of Trump’s four-year term will be played on a far harsher political landscape. And these normal headaches of governance are not the only things threatening to drag on Trump. The ongoing Mueller investigation into Russian collusion in the 2016 election, for example, will continue to take up significant political bandwidth and eat away at the president's finite political capital. These internal woes have added economic uncertainty, as has the Federal Reserve's recent decision to continue modest interest rate hikes. Overly hawkish monetary policy could send markets tumbling, harming investors directly. If things get bad enough, Trump might find little alternative than to bend.
Meanwhile, Xi Jinping, Trump’s Chinese counterpart, enjoys a much more placid governing experience. Having effectively crushed all opposition within the Chinese Communist Party, Xi now wields near-limitless power within the Chinese state. The old system of collective leadership has been cast aside in favor of one-man-rule. Indeed, Xi is so firmly situated at the pinnacle of power that he was able to eliminate the pesky constitutional rule that would have limited him to a mere two terms as president.
Now effectively president-for-life, Xi naturally has a very different set of priorities from those of Trump. The American president can at best hope to win a second and final term in 2020, but either way he will be out of the picture ere long. Given Trump’s deeply negative approval rating, it is not unreasonable for Xi and his inner circle to conclude that Trump can be waited out.
Xi has the luxury - and necessity - of thinking for the long term. He is building a new China in his image, and that is a process that will likely span decades. That cannot be overlooked when considering his actions to date, or in attempting to forecast how he will act going forward.
The War Continues
The outcome of the trade war obviously matters to both sides, politically and economically, but Xi enjoys the option of waiting until 2020 before even having to consider seeking a face-saving peace. Trump, on the other hand, is being harried by an emboldened opposition, as well as by members of his own party.
Trump has built his presidency around the narrative of forcing America’s trading partners to acquiesce to better deals. If he fails to deliver on that promise with regard to China, it will likely have a negative impact on his re-election prospects. China knows that, which is why it actually has a political interest in letting things continue as they are for the time being. The less time Trump has to act, the less risk to Chinese interests.
With political pressure from the emboldened Democratic opposition, as well as from within his own party, Trump has little time to post a significant victory in this trade war. The December accord reached between Trump and Xi, which alleviates a few of the harsher retaliatory tariffs on each side, is indicative of the asymmetric time pressures confronting the two leaders. China agreed, in the words of the Financial Times, “only to import more of what it doesn’t want to make at home.” In other words, the trade “ceasefire” did little for the American cause, other than to give Trump the appearance of a win.
If anything, the latest accord plays further into China’s hands as it runs down the clock on the Trump administration. Xi has bought himself some breathing space, which is a boon given the mounting signs of domestic economic weakness (China’s manufacturing sector actually contracted in December, so the reprieve is undoubtedly welcome). The American economy, on the other hand, has been holding up rather well, though there are signs of weakness there as well (one need look no further than the market chaos engendered by the recent modest Fed interest rate hike to see signs of heightened fear and market fragility).
We thus conclude that the trade war is far from over. The December “ceasefire” was an agreement to kick the can down the road. But the underlying disputes remain largely unchanged. So long as China can keep the uneasy peace, or even prevent more than modest intensification, it should be able to weather the Trump storm.
For investors, this is a crucial period. If China bends and an "honorable peace" is agreed, it will undoubtedly put some wind in the market's sails. If Trump capitulates, there may be some volatility thanks to fears of rising Chinese power at the expense of the United States.
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.
Source : https://seekingalpha.com/article/4231926-trade-war-may-lose