A preview of the Sino-American Trade War 2.0

China’s leadership was caught off-guard in 2016 because few people expected Trump to win the election. This time, Beijing has had plenty of warning, and it is far better prepared for Trade War 2.0.

The key difference is the divergence in the path of economic growth, as signaled by the bond market. Chinese 10-year yields have plunged below 2%, which is a sign of a dramatic slowdown. By contrast, U.S. 10-year Treasury yields have risen, which reflects concerns over a heightened fiscal deficit and rising inflation.

 

In the face of economic weakness, China seems to be preparing for Trade War 2.0 on a different dimension of belligerence. China has embraced von Clausewitz’s famous quote on war: “War is merely the continuation of politics by other means.”

Investors should prepare for greater newsflow volatility and rising geopolitical risk in the months ahead.
 

 

A teetering economy?

Bloomberg reported that the markets are sounding the alarm over the Chinese growth outlook. China’s 30-year bond yields have plunged to all-time lows and they are now below Japan’s 30-year JGBs, which is causing concern over the Japanification of China and a possible Lost Decade.

While an echo of post-bubble Japan is far from certain, the similarities are hard to ignore. Both countries suffered from a real estate crash, weak private investment, tepid consumption, a massive debt overhang and a rapidly aging population. Even investors who point to China’s tighter control over the economy as a reason for optimism worry that officials have been slow to act more forcefully. One clear lesson from Japan: Reviving growth becomes increasingly difficult the longer authorities wait to stamp out pessimism among investors, consumers and businesses.

 

 

The combination of a weak economy and the threat of Trump tariffs has dramatically weakened the Chinese yuan. The weakness in the currency against the USD is likely to exacerbate trade tensions in the coming months.
 

 

 

China’s pre-emptive response

In the face of growing economic weakness, Beijing has chosen to respond in other dimensions of conflict in a “wolf warrior” in a pre-emptive fashion. Here is what China has done in the recent past:

• Chinese intelligence hacked the U.S. Treasury Department (NY Times). Intruders accessed Treasury user workstations and stole unclassified documents.
• Chinese hackers have compromised major U.S. infrastructure, such as ports and power grids in anticipation of an invasion of Taiwan (WSJ).
• China conducted a massive naval exercise off the Taiwan coast in early December (Reuters). The scale of the exercise was the largest in decades. News outlets reported that 90–100 ships were deployed across the Western Pacific.
• The PLA Navy and China Coast Guard jointly carried out an exercise similar to a naval blockade in the Miyako Strait in December (Japan News).
• China marked Mao’s birthday in late December by launching a new generation of amphibious assault ship in late December (Naval News).
• China is building a fleet of naval barges to support amphibious landings (Naval News). The barges are reminiscent of the Mulberry Harbours used to support the D-Day landings and were used to help supply troops after they established a beachhead. This is an ominous sign that China is quietly preparing for an invasion of Taiwan. It’s only a matter of time.
• Taiwan asked South Korea to help investigate a Chinese-owned ship suspected of cutting a subsea cable off its northern coast (Financial Times).
• China banned exports of “dual-use items” related to gallium, germanium, antimony and superhard materials to the U.S. (Reuters).

I could go on, but you get the idea. Only the last measure, the banning of selected rare earth exports, was a trade response. The others were in the intelligence and military dimensions.
 

 

Investment implications

As we count down to Trump’s inauguration, we don’t know the specifics of Trump’s tariff measures, but the investment landscape is becoming clear. Here are the main investment implications of the Sino-American Trade War 2.0.

Chinese equities are uninvestable. Even though the S&P 500 has outperformed the rest of the world since the GFC, the accompanying chart shows that Chinese stocks (in USD terms) have traded sideways over the same period, while Europe and Japan have climbed. This does not mean that traders can’t profit from swings in Chinese stocks, it’s just that the Chinese market is an unattractive asset class over the long run.
 

 

Consider de-dollarization and gold as investment themes. Broad-based sanctions on Russia since the onset of the Russo-Ukrainian War taught America’s adversaries that they should diversify away from the USD as a reserve currency. While the process will take decades, investors can see the effects on the price of gold. Not only has gold broken out to all-time highs in USD terms, it also reached all-time highs in all currencies. Most notably, it has been strong against the Swiss Franc (CHF), which is regarded as a “hard currency”, and the Chinese yuan (CNY), which is reflective of Chinese private and central bank demand.
 

 

The strength in the gold price is occurring in the face of outflows in GLD, the popular gold ETF, which is reflective of Western investor skepticism about the sustainability of a gold bull.
 

I further underline my view that investors should prepare for greater volatility in the coming months. Bloomberg reported that a “Trader Who Made Billions in 2008 Returns to Bet on Market Swings”. Steve Diggle, who made $3 billion in 2007–2008, is seeking to raise up to $250 million for an upcoming volatility trading fund. Diggle cited “potential flash points are the stretched valuations of U.S. stocks, the country’s prime office market glut, elevated federal debt and tight credit spreads.” While Diggle’s sources of potential volatility do not include China, investors need to consider geopolitical risk as a fat-tailed risk in over the next four years.

While risk levels are heightened, investors should also be prepared that the Sino-American trade dispute is resolved in a relatively benign manner. Noah Smith wrote an opinion column, “How we’ll know if Trump is going to sell America out to China”. While both sides of the aisle in Washington now regard China as an adversary, Trump has been known to backtrack on his tough stance on China, such as the reversal of his views on a bill to require the divestment of TikTok by its Chinese parent ByteDance.

The key decision to watch, according to Smith, is whether Trump trades away the export controls on advanced semiconductor technology. The semiconductor ban worked to hobble Chinese artificial intelligence research. A reversal of the export controls would considerably turn down the temperature of trade friction.

In conclusion, an economically weakened China is preparing for Trump’s tariff war with an array of assertive measures in the intelligence, military and trade dimensions that may not be fully be discounted by the market. I continue to believe Chinese equities are an uninvestable asset class, though traders could profit from swings in that market. Investors should consider gold as a de-dollarization play, and possible commitments into tail-risk volatility.