Trump's Trade War May Test Investors More Than China's Economy
President Donald Trump's new tariffs are unlikely to prompt capitulation by his Chinese counterpart, Xi Jinping.

To make America great again, President Donald Trump is trying weaken China. That may turn out to be easier said than done.

Trump's blunt tactics to cut the trade deficit with China have rattled corporate executives, investors and even the Federal Reserve over the prospect of higher costs for consumers and U.S. importers including Walmart Inc. (WMT) . Along with signs that Trump's trade war against China may last much longer than many investors currently expect, there are fears that U.S. exporters could suffer lower earnings as a result of retaliatory tariffs imposed by China.

The dispute escalated this week as Trump promised to follow through with 10% tariffs on $200 billion of Chinese imports starting next week, raising this year's total to $250 billion. China immediately promised to enact retaliatory tariffs on an additional $60 billion of goods and services from the U.S. An unnamed senior Chinese official told the Wall Street Journal that the country would not negotiate "with a gun pointed to its head."

China's leaders, which last year mounted a broad effort to reduce borrowing in the country's financial system and corporate sector, have since shifted to stabilizing their domestic economy in the face of the trade pressures. Steps include cutting electricity prices for industry while slashing taxes on trucks and storage facilities and canceling some highway tolls, according to China-watcher Diana Choyleva at Enodo Economics.

Choyleva estimates that China's economy, the world's second-largest after the U.S., grew by 4.4% last year, down from 6% in 2016. But since then, growth has accelerated to 5.6%, she estimates. At the same time, a slide this year in the country's currency, the yuan, has boosted domestic revenue for Chinese exporters, since many of their sales contracts are priced in dollars. For comparison, the U.S. economy grew at a 4.2% annual clip in the second quarter, eliciting self-adulation from Trump

"For now, China's policymakers feel confident that they can withstand a drawn-out confrontation with the U.S., on both trade and strategic issues," Choyleva wrote in a Sept. 6 report.

Dec Mullarkey, managing director of investment strategies at Sun Life Investment Management, which oversees $47 billion, believes China has the ability to withstand a full-blown trade assault. Doing so is critical to Chinese President Xi Jinping's push to establish his country as a global leader, both on economic and strategic issues.

And he thinks U.S. stock investors are not properly accounting for the risks; the Standard & Poor's 500 Index and Dow Jones Industrial Average have climbed to all-time highs. China's exports to the U.S. account for just 4% of gross domestic product, so any hit from Trump's tariffs should be manageable, according to Mullarkey.

"They're at an inflection point where they want to establish that this is the new China, that they've arrived on the world stage, and they do not want to be seen as vulnerable to outside intimidation," he said in a phone interview. "Right now the U.S. markets are underpricing what could be a very protracted trade spat."

Trump's tariffs on the latest round of $200 billion of Chinese imports are set to increase to 25% at the end of this year.

Economists at Deutsche Bank, the German lender, estimate that such a level would add about 0.5 percentage points to the U.S. inflation rate, currently running around 2%. The extra price increases could put pressure on the Federal Reserve to raise interest rates further to head off inflation, which in turn could slow economic activity in the U.S.

According to Fed officials, some businesses in the U.S. have already canceled or delayed purchases of new plants and equipment -- crucial investments for future earnings growth -- because of the threat of a trade-related economic slowdown.  

"While we still believe that there is scope for a settlement sometime in the first half of 2019, risks that the trade war goes beyond our current assumptions have increased," the Deutsche Bank economists wrote this week in a report.

TS Lombard, an economic forecaster, says China is "feeling aggrieved" over the Trump administration's demands, since the assault represents a threat to the ruling Communist Party's power.

"As a result, Beijing has also shifted to a harder line and is likely to shun new talks, blaming the U.S. for a lack of sincerity to engage in negotiations," according to a report this week from the London-based firm.

Of course, Trump could always choose to back down. If his administration cut an agreement prior to the November elections in the U.S., stocks might jump, while solidifying support among business-friendly Republican voters who just want the trade war to end.

"If he feels he needs to show a win, then he can come right out and say they've got an agreement," Sun Life's Mullarkey said.

Based on Trump's track record, backing down looks unlikely.

"China has been taking advantage of the United States on Trade for many years," Trump tweeted this week. "They also know that I am the one that knows how to stop it." He also wrote: "Tariffs have put the U.S. in a very strong bargaining position."

Such an October surprise might be the president's best chance for salvaging victory in his trade crusade.

Because China is unlikely to concede.

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