After decades of theft of American knowhow (according to President Trump), and months of tensions between the World’s two largest economies, US tariffs on $34billion of Chinese products came into effect on Friday 06 July at 5am London time. These measures are equivalent to just 0.1% of China’s GDP, yet tariffs on another $16billion of goods could follow in two weeks and, in the most aggressive scenario, the final total could eventually reach $550billion.
Clearly Mr Trump is testing China’s (and the World’s) willingness to retaliate. Game theory suggests that a rational diplomatic solution will be reached, as both sides have too much to lose in the event of all out conflict (as was the case with North Korea). However, the main problem may not be irrationality, but miscalculation. Both sides might underestimate the economic impact on their respective economies as well as political consequences (e.g. in upcoming US mid-term elections). Additional concern is that while initial trade war threats were targeting only China, now they cover pretty much all America’s trading partners, with a particular emphasis on Germany’s car manufacturers.
Trump’s success has been mixed so far. Germany was the first to offer concessions. On Thursday Chancellor Merkel seemed to be open to cutting the tariffs. She said that such a deal would need to be offered to other countries that export cars to the EU, too, if it is to conform to World Trade Organization rules.
At the time of writing, China confirmed that its countermeasures against “unfair tariff” actions have taken effect (it previously vowed to target hundreds of US products within agriculture and farming, as well as autos).
The key question for financial markets is whether this will trigger fresh volatility, or is an escalation of the trade war already priced in? To start with, volatility has already been elevated. The CBOE’s Volatility Index, known as the VIX, has averaged 16.3 this year, compared to 11.1 in 2017, representing a nearly 50% rise. It now stands at 15.1, implying that the Market anticipates the S&P 500 Index moving by +/-1% every day over the next month. And while the S&P 500 Index has been on an upward trend in the last three months, the Shanghai Composite firmly entered bear market territory, falling 23% since its peak in January.
In Europe, carmakers rallied 3.4% on Thursday, on the back of potential discussions on lowering tariffs with the US, while the Chinese Index closed 0.5% higher on Friday, three hours after tariffs kicked in, suggesting that Markets had already been primed for adverse news on global trade. There could be more developments over the weekend, but as it stands now, the start of the trade war has not claimed any victims yet.