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Curatia Analysis for Mon, May 13

Trade Wars Volume XXIV: Markets React Uncertainly To Spiking Tensions

Trade tensions quickly became the dominant issue facing global markets last week as the Trump administration followed through on a threatened tariff hike on Chinese imports and Beijing promised retaliation even as US-China trade talks resumed.

Despite the commotion, market reaction was largely contained. The VIX settled just above 16 Friday, with the S&P 500 retreating 2.2% for the week. Those modest movements highlight the soothsayer’s dilemma that is reading the potential ripple effects of simmering trade tensions on a spate of forces influencing markets and the global economy.

(Fleeting) Friday Optimism

The S&P 500 (+0.4%) crept cautiously higher Friday as US-China trade talks continued despite an overnight US tariff hike from 10% to 25% on $200B worth of Chinese imports and Beijing’s promise of retaliation.

Chinese stock market reaction was similarly counterintuitive: The Shanghai Composite Index finished 3.1% higher despite the destabilizing news after state funds stepped in to prop up Chinese equity markets.

Wide Range of Outcomes

Analysts have argued escalating tensions could precipitate a market correction following a stellar Q1 that left stocks vulnerable to a pullback. Behind those expectations lie the heightened risk of a prolonged trade war and, as a result, anemic economic growth.

But Friday’s market reactions imply investors are holding out hope that a US-China trade impasse could still prove less damaging to markets than once feared. The US has other levers to pull to stimulate the economic growth Donald Trump has made the central pillar of his presidency.

Market odds of a Fed rate cut by year-end to kick-start growth have jumped 10% versus a week ago. Moreover, the US could dial back tariff threats against European exporters including German auto manufacturers as it seeks allies in its bid to hem in China’s global economic influence.

Those dynamics have left markets uncertain how to interpret a wide range of potential outcomes stemming from rising trade tensions.

Diverse Trading Strategies

In the near term, that uncertainty figures to stoke volatility as investors read the tea leaves of Trump tweets, Chinese retaliation, and economic indicators due this week with renewed sensitivity. Asian markets opened moderately lower Monday morning, with the Shanghai Composite Index down 0.9%.

Amid brewing turmoil, some investors are looking to dust off last year’s trade war playbook, pivoting away from credit, emerging markets, and carmakers in favor of US small-cap stocks and defensive sectors like utilities and real estate, all of which derive revenue primarily from domestic sources.

Based on analysis of last year’s spikes in trade tensions, Goldman Sachs suggests investors favor service providers over goods manufacturers.

Others are adopting new strategies such as shorting junk bond ETFs, reasoning that overstretched companies in debt will be the first to falter in a lower-growth environment.

Chinese retaliation could take the form of devaluing the yuan, halting US soybean purchases, or the so-called “nuclear option” of dumping Treasuries.

Rising tensions between the US and Iran could also drive oil prices higher, conspiring with tariff-related growth risks to deal equities a heavy blow and spark a flight to the safety of gold, oil, and US Treasuries.

Aura of Inevitability

The odds of a US-China compromise appear to be fading after the US said it would begin planning an additional round of tariff increases and Beijing told Washington it must “remove all extra tariffs” and “set targets for Chinese purchases of goods in line with real demand.”

The growing impasse is creating an aura of inevitability around a prolonged US-China trade conflict in which the current frictions represent merely an initial skirmish. In that context, the trade war takes on the contours less of a Trump administration power play than of a predictable response to Beijing’s challenge to a century of American global economic hegemony.

In the last century, the US resisted a Soviet challenge to that hegemony by adopting a policy of containment and economic isolation — a playbook it is arguably trying to resurrect and apply to China today.

In that contest, the biggest variable for financial markets in both the short and long term could be whether regional flows of goods and capital trump global integration.