While the main event this week will be the official start of Q1 earning season which is expected to blockbuster, if mainly at the EPS level thanks to Trump's corporate tax cut...
... the biggest risk overhang remains the escalating trade war with China, and specifically Beijing's retaliation to the unexpected Trump escalation in which he told the USTR to consider an additional $100BN in tariffs for a $150BN total.
As previously discussed, one potential complication in the Chinese retaliation is that the US does not have $150BN in exports to China, which means that Beijing will need to get creative in crafting its escalating response.
That said, China has no less than five options how to escalate, the problem being however that all five are what some have dubbed "nuclear" choices, and include:
- A Currency Depreciation. A sharp, one-time yuan devaluation, like the one Beijing unexpectedly carried out in August 2015, could be used to offset some of the effect of tariffs.
- Sales of US Treasurys. Chinese authorities could sell some of its large official-sector holdings of US Treasuries, which would lead to a tightening of US financial conditions.
- Block US services. Chinese authorities could limit access for US companies to the Chinese domestic market, particularly in the services sector, where the US exports $56 billion in services annually and runs a $38 billion surplus
- Curb US oil shipments. According to Petromatrix, China is one of the biggest importers of U.S. crude oil at 400kb/d, so any counter-tariffs on crude could become very heavy for the U.S. supply and demand picture. Such a move would weigh on U.S. prices and spill over to global oil pricing. As Petromatrix adds, the market would need to start balancing downward price risk of trade-war escalations with upside risk of Iran sanctions as oil flows could be about the same.
- Blocking rare-earth exports. China has a near global monopoly on the production of rare earths, which are a critical component in all high-tech devices such as cell phones, computers, fighter jets and cruise missiles. In national defense, there is no substitute and no other supply source available. When China blocked rare earth exports to Japan over a territorial spat involving the East China Sea in 2011/2012, the price of rare earths soared.
However, as pointed out previously, any escalation involving one or more of these countermeasures would assure an even more aggressive response by the US, which as we reported last week has deployed three carrier battle groups to the South China Sea, in a less than subtle message to Beijing.
Putting all of the above together, China watchers, traders, pundits, politicians and virtually everyone else wants to know just one thing: what will China do?
Conveniently, on Sunday China's state-owned Global Times newspaper, the tabloid where all nationalistic propaganda for mass popular consumption is printed, writes that Chinese authorities have "ample weapons to prevail if the US escalates trade war", explaining Beijing's strategy as follows: "the Chinese authorities will take all necessary measures to minimize the losses for Chinese companies and individuals. Nonetheless, the US, the world's largest economy with a GDP of approximately $19 trillion, has less endurance for a full-blown trade war."
Echoing the Chinese ministry of commerce, the article notes that while China does not want a trade war with the US, which is one of its most important trade partners, "if US President Donald Trump starts a trade war, China will fight to the end to defend its interests."
The Global Times author then explains what countermeasures China plans on rolling out in the immediate term, starting with export subsidies, offsetting the US tariffs:
In an all-out trade war, offense and defense are equally important to winning. The Trump administration said it will impose punitive tariffs on Chinese imports ranging from industrial robots and electric vehicles to locomotives and jet engines. If this measure is carried out, China can provide export-promoting subsidies for companies that export goods on the list.
Author Hu Weijia also claims that behind the trade dispute is the US concern over the "Made in China 2025" program, which aims to upgrade China into a manufacturing superpower. However, he claims, Trump's efforts will be in vain as "the Chinese government is highly able to mobilize resources and coordinate action to promote its strategy and protect domestic employment."
In this context, export-promoting subsidies are just one of several options for China "to use in tackling a trade dispute with the US" according to the Global Times. China also suggests that the asymmetric distribution of gains vs losses in the US, will make it easy for Beijing to win a trade war.
In the US, some interest groups such as steel companies benefit far more than others from trade protectionism, while the trade disputes potentially hurt exports of US farm products.
However the most notable suggestion in the Chinese propaganda outlet, is that the US stock market us the most important pain-transmission mechanism, something Trump himself appears to have realized with his Friday warning to investors to prepare for "pain" in the market. Here's how China sees its leverage, which can be simplified with the following: S&P500.
US stocks saw deep losses in recent days amid jitters about Sino-US trade tensions. While it is hard to win a trade war with punitive tariffs, it is more difficult to protect people from feeling pain in the fight.
In other words, instead of the Bernanke, or the Yellen, or the Powell put, traders now have something new to worry about: the Chinese call.
Which brings us to China's bottom line, and the reason why Beijing isn't contemplating a nuclear option, at least as of this morning: China is confident that given enough pressure, primarily in the form of falling stock prices, the US population itself will demand that Trump back off from the trade war:
Because of an uneven distribution of interests, US society is likely to be more and more split in its attitude to the trade war with China, making the trade war very costly for Trump.
China is probably right, the only question is how much pressure - in the form of S&P downside pain - can Trump withstand before he backs off. We may find out this week.