An immediate US-China trade war escalation
Whether the “sell in May” is a coincident again for 2019 or not, the return of US-China trade tensions obviously resulted in Chinese assets leading the broader Emerging Market assets lower with equities experiencing the most pain last week. The US administration decided to raise additional tariffs on $200bn of Chinese exports from 10% to 25% on May 10. In return on 13 May, China retaliated by announcing plans to impose 20-25% tariff (from 5-10% previously) on $60bn of +5,000 American imports starting June 1. The latest breakdown shows that there are still large discrepancies between the two countries and they still haven’t found the right formula to negotiate effectively. With rising pessimism, the MSCI China, MSCI Asia and MSCI EM index has tumbled by 3.9%, 4.1% and 4.3% respectively last week.
Both sides have worked hard to calm down the market since the end of discussion on Friday and emphasizes that negotiations will go on, but people close to the talks say has been a bigger erosion of trust and there are widening fundamental differences between the two sides. One of the key arguments between the two countries has been US plans to keep some tariff in place after the deal, which is unacceptable in China’s point of view. Another major area of conflict has been the long arguing intellectual property right, which are unlikely to find a common ground sooner or later.
What’s next and the economic effects?
However, the worst has not yet to come as the U.S. may backfire again by putting another 25% tariffs on $325 billion in Chinese goods that remain untaxed. On the other hand, China’s retaliation could also go beyond the goods trade and target services, especially in the finance, tourism and cultural sectors. According to UBS, the current trade war of 25% tariff on $200bn Chinese goods is likely to lower China’s real GDP growth by 30-50bps in the next 12 months and the growth could slow further by 120-150bps if a full-blown trade war happens. On the other side, UBS estimates that the negative impacts to U.S. GDP growth is about 20-35bps ($45-65bn) in the next two quarter and the impacts can be worsen to 75-100bp ($150 to $225bn) of GDP growth over the next four quarters if situation get worse.
The market impacts…
As we mentioned in early May, the extremely low market volatility YTD is unlikely to sustain especially during the late economic cycle. The VIX spiked up to 20.6 on May 13 from only 12.9 in just only one week. Asian equities including HK/China before were pricing in limited risk of the US/China talks breaking up. Therefore, we saw a big correction for Asian equities over the last few trading days, and there could be another 10-15% downside risk in the full-blown trade scenario as market is still pricing in a low-single digit and double-digit earnings growth for Asia and China for 2019, respectively. On the currency side, CNY has been weakening again since the news flow last week and it could break above 7.0 in the worst-case scenario. However, we believe the Chinese government will continue to refrain from allowing for a large CNY depreciation, e.g. to above 7.3, as a sharp depreciation could destabilize confidence and lead to more capital outflows. Nevertheless, a slump in China’s currency would be a negative to Asian currencies, in particular KRW, THB, MYR and SGD historically have had the highest sensitivity to RMB weakness (of ~0.6). On the other hand, a depreciating CNY also tends to weigh on Hong Kong’s equities as Hang Seng Index’s companies generate about 60% of their earning in CNY.
The key watching date
According to U.S. officials, the potential 25% tariffs on $325 billion Chinese goods would not take effect until late June at the earliest. The two countries still have another month to reach a deal, while the G20-meeting on June 28-29 in Osaka, Japan plays an ever-more important role as Chinese President Xi and U.S. president Trump are likely to meet and have a discussion on trade there. We expect market volatility to remain high before the G20 summit and suggest investors not to be too speculative, while it may be a good to rebalance your portfolio and reduce the weight of risky assets.