What will Trump do with China?

The Rembau Times explains why the only rational decision for President Trump to do is to stick it to China, raise the tariffs to 25% and claim victory towards the end of the year. But this does run the risk that things could go bad and may see the US and China square off over Taiwan. (Updated on Feb 19 , 2019 - there is a deal!!!)

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The US – China trade negotiations are right now at a very critical point. If things go well, markets may rally a little bit more, if things go bad, expect a 1,200 point sell off on the Dow Jones Industrial average.

For those trading with China, the impact of an increase in tariffs to 25% could be much more damaging. This is because international trade is conducted based on a set of conventions called Incoterms. If a US buyer bought goods based on any other term either than Delivery Duty Paid (DDP), they risk having to pay 25% more for their goods as the responsibility to pay the custom duties falls on the buyer. If a Chinese seller sold their goods based on DDP, they may not even clear the goods through customs as it would have cost 25%.

That is why there is currently unprecedented port congestion in the at the Los Angeles-Long Beach port complex, having bled into intermodal rail operations and drayage to regional warehouses. Every logistic firm shipping goods from China to US is under pressure to get the goods cleared by customs before March 01.  Interestingly, since the voyage from China to US takes approximately 20 days, all these goods which are clogging up the US ports would have been shipped out of China in January.

Thus, those claiming that China’s economy is not in bad shape are kidding themselves, export growths of 10% was skewed higher due to the Chinese New Year holidays as well as the potential impact of President Trump raising tariffs to 25%. Next month’s trade data from China should show what The Rembau Times has called – a marked slowdown in Chinese industrial production.

While logistics supply chains are currently treating the risk of tariff increase with some degree of seriousness, financial markets are currently treating March 02, 2019 as a non-issue. Of course, financial markets have the additional benefit of being able to react to the expected probability of the final outcome closer to the deadline date. We question why financial markets are not taking President Trump’s threats seriously when those in the real economy had actually done so.

We reviewed 7 pronouncements, including President Trump himself and let’s see how they stack up:-

Analyst and personality calls. Click here for full document

Of the sample, Kenneth Rapoza from Forbes seems to be the outlier as he predicts that tariffs will increase to 25% come Mar 02, 2019 or in about 14 days time. As fate has conspired, Mar 02, 2019 falls on a Saturday.

From a financial perspective, this creates unprecedented volatility around options expiring on Friday March 01, 2019. Now imagine if there is no deal by then? I would certainly be buying as much portfolio insurance as required, called puts, as these contracts are rather cheap at the moment.

So where do we go from here?

From a negotiation analysis point of view, China is projecting strength and Dr. Michael Ivanovitch, an independent analyst, figures that President Trump overplayed his hand because he reached for something that China was not willing to accede to. He feels that President Trump will want to settle for any deal, no matter how rotten it is just so that he can claim a victory. The President’s tweets on 16-Feb seems to confirm this view as he was talking enthusiastically about the “China trade deal.” If there is a deal done before March 02, then President Xi wins and President Trump loses.

Currently, at the time of writing, President Trump is railing against Andrew McCabe, the ex-FBI Deputy Director and trade does not seem to be on his mind.

The entire premise of this is that President Trump will be unwilling to do anything to cause the stock market to sell-off. With the Dow Jones at 25,900, President Trump may be tempted to see how far he can juice the market to go past its all time high of 26,900.

Conversely, what if Trump figures out that markets go up and markets go down and the only time it will actually matter will be come November 2020, which is still 20 months away. Settling for an empty deal at such an early stage will make him look weak politically since the US public sentiment, both among Democrats and Republicans is to sock it to China.

That leaves us with two alternatives, either take the deal or go for the kill and raise tariffs to 25%?

So how will President Trump react?

President Trump’s decision making is nothing like President Obama. President Obama was easily read from a mile, but President Trump keeps his detractors guessing on what is his next move.

We know from the Apprentice that Trump’s decision making is largely influenced by on the spur arguments. He can be persuaded to make tough calls, after all he has just declared a national emergency in order to build the border wall.  We believe that there are only two viable options on the table – either Trump takes the deal or Trump calls China’s bluff and raise tariffs to 25%.

Given that China is now only offering a crap deal, what would you do if you were President?

The answer is obvious, you will kick China in the teeth, raise tariffs to 25% and keep the issue alive so that you can get a better deal towards the end of December 2019. China will then have two options – continue to negotiate with the US or break off negotiations.

China will probably break off negotiations to save face for President Xi. However, he will face a huge problem on his hand as rural workers who migrated to the coastal city centers may be laid off, leading to social instability in China.  This will force President Xi to do one of two things. Either re-enter negotiations with the US or divert the issue by making claims on Taiwan. We think it is more likely for China to make a military play, but President Xi himself may come under increased pressure within the Chinese ruling establishment who would be angry that President Xi overplayed his hands.

So we are then left with two scenarios.

Scenario 1 – China Re-enters negotiation.

At that point the US markets will have sold off and reached a bottom since earnings expectations for 2019 are very low. The only way to secure re-election is to time a deal in 2020. That will give the markets plenty of juice to rally into 2020 with expectations of corporate earnings to increase in 2021.

Scenario 2 – China prepares to take over Taiwan?

This scenario is probable as well, and then President Trump enters 2020 election cycle on the back of a potential military conflict with one of the world’s largest superpowers.

Updates: Feb 19 , 2019

Ok there is a big change on our call based on Trump’s latest tweet. It is obvious that he is a slave to the market and is going to accept whatever President Xi is throwing at him. Our modified call is Xi Jinping wins, tarrifs are off. We hate to this but the tweet is the tweet!

 

1 COMMENT

  1. I bet China will use it’s old way, devaluing yen to conter the rise in price due to the trade tariff. So we might see yen drop past 7 and reach 8 relative to USD.

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