The U.S. China Trade War\'s End Gets Dimmer

The past few days have seen trade war tensions escalate again with a focus on the United States and China, as an exchange of tariffs have been quickly implemented, negotiations have stalled, and China is now seemingly trying to determine now ways to inflict economic retaliation on the U.S. given that it is about to quickly reach the maximum level of U.S. imports it can tax.

As shown below, the Shanghai Composite and Hong Kong indexes have fallen significantly in the past three weeks or so, as has the iShares China Large-Cap ETF (FXI) run by Blackrock (BLK).

Moving forward, I believe the continuing trade conflict will result in a net downgrade to Chinese market growth as the two likely results are either a new set of trade rules that reduce Chinese companies' current competitive advantages or a long-term tariff structure that locks in current disadvantages for an uncertain time to come.

Chart^SSEC data by YCharts

Beyond Goods Exports and Imports, Trade Conflict Could Escalate to a Wide Array of Economic Activity

There are also two positive scenarios that are more positive for Chinese stocks, whereby either the trade conflict ends without significant changes to current trade rules or Chinese companies are able to sufficiently find new market opportunities with other nations to make up for the loss in trade with the United States.

However both those options remain unlikely. In the first case, the United States government has set quite a firm line in the sand seemingly at the amount of effort, and stock market damage, it will go to in gaining some kind of change in trade rules.

Secondly, the United States market amounts to such a large depository for Chinese goods and services, over $505 billion in 2017, that replacing that export activity with places like Europe, emerging markets, and other Asian economies would take a long-time to achieve comparable market penetration and economic activity. In the meantime the 25% harsh tariff tax wreaks havoc on that economically-sensitive trade.

It also seems that there are already serious plans being made for a long-term trade war as current reports on trade negotiations between the U.S. and China show little progress, if any at all, seems to be being made.

Given that China will very soon reach its maximum limit of tariffs placed on U.S. goods, it appears they are now exploring other economic constrictions such as increasing audits and inspections of U.S. imports, halting M&A activity by U.S. companies in China, reducing some of the "opening" seen this past year, and expanding the tariffs conflict to services as well.

It is worth noting that Chinese companies may face similar regulatory action in the United States, as the recent dispute with ZTE has been a small example of, thus increasing the potential maximum escalation of the trade war.

The impact of all this means more headwinds that may even increase beyond the totality of current U.S.-China official goods imports-exports, as services now also faced tariff action and more complex economic regulatory punishments seem ready to be implemented.

(Source: The Wall Street Journal)

Currency Impact of the Chinese Yuan and Hong Kong Dollar

As with all international companies, securities, and in particular ETFs, it is also worth examining the currency impact. The iShares China Large-Cap ETF is primarily denominated in the Hong Kong dollar rather than the Chinese yuan. The Hong Kong dollar has hit a historic low against the United States eollar, although the total impact of that currency depreciation remains slight.

Going forward, even with the expected continuing rally of the United States dollar the effects on the HKD-USD exchange rate in particular, and therefore negative currency impact on the FXI ETF, are likely to continue to be small due to the pegging of the HKD.

ChartHong Kong Dollar to U.S. Dollar Exchange Rate data by YCharts

In this situation the Chinese yuan also has importance, as it is the currency to which the Chinese companies that are part of the FXI ETF digest and report their revenue. We've seen in the past few years a rallying and then depreciation of the yuan in relation to the U.S. dollar, as China has partially unpegged it from its previous devalued state.

On a more micro-scale, the yuan actually rallied moderately this year before dropping amid the current actual tariff implementation.

While the impact of this currency move is extremely complex and hard to precisely determine or predict, I believe the impact may be that the tariffs will have increased impact on Chinese goods due to the taxes having increasingly greater value in the yuan, particularly as the dollar continues to rally.

ChartChinese Yuan to U.S. Dollar Exchange Rate data by YCharts


The eventual likely result of the current conflict is a change in trade rules between the U.S. and China in my opinion, although how long that takes and what kinds of trade disputes and tariffs we go through in the meantime remains uncertain.

I believe this is the likely result because China-U.S. economic relations remain an essential source of economic might for both countries, with a change in trade rules not necessarily hurting China too much while being of significant comparative benefit to the U.S., thus making the U.S. likely willing to stick out the negotiations and gain eventual concessions.

In the meantime, it looks like the trade war ante is entering a new stage as actual tariffs are increasingly implemented and both sides seemingly are planning their long-game. As a headwind for Chinese stocks, there seems to remain a lot of room to go for the short and medium term in terms of real impact on revenues and earnings.

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