Authored by Michael Zezas, Chief Public Policy strategist at Morgan Stanley:
Investors are obsessed, trying to figure out what happens next in the US/China trade dispute. Will the US call China? What do the negotiators really think? Does this last three weeks or three months? Our answer: you could be starting with the wrong questions.
First, let’s look back. It all seemed to be going so well. After market sell-offs sent signals to the US and China about the costs of trade tensions, they sat down at the G20 in November, called a truce, and appeared close enough to a deal to start planning for a signing ceremony. Then came the week of May 5. The US claimed China had moved the goalposts on key issues and announced another tariff increase, with preparations to levy tariffs on another ~US$300 billion of imports. China responded with counter-tariffs and heated rhetoric. Escalation was back, but the market response was relatively muted. After a 3-4% down move in the S&P from all-time highs and about a 7% down move in the Shanghai Composite, both indices remain well above pre-G20 levels. This suggests the recognition of heightened uncertainty, but no clear idea of what comes next.
It appears that investors are trying to gauge trade risks by focusing on near-term catalysts. We’re often asked what key players are saying, what might happen at the next G20, where that meeting fits in the timelines for tariff events, and what unconventional action each side might take. But these questions can be counterproductive. Answers require us to intuit the intentions of key players around specific details, while we can only parse their broad intentions from public statements and reporting. Furthermore, this approach risks overemphasizing isolated bits of evidence.
Rather than guess at the next headline or meeting, define the dynamic at play.
Game theory takes us back to what shaped our call in 2018. Both sides will continue to escalate until clear market or economic weakness pushes them to reengage. Hence, investors should act as if the next escalation will happen until markets price it in. The situation resembles a repeated Prisoner’s Dilemma game. Both sides start by escalating, perceiving better payoffs for doing so. They can cooperate later on if they realize that the rewards for payoffs from cooperation are greater than from further escalation. Consider:
- This isn’t posturing, meaningful disagreements exist: Early speculation the week of May 5 was that the game hadn’t changed, rather both sides were framing their compromises for domestic audiences. But the US soon highlighted new areas of disagreements, confirmed by the Chinese side, around IP protections and how quickly to remove existing tariffs.
- These conflicts reset the payoffs, suggesting that escalation is preferable at this point to meeting the other’s demands: For one side, and possibly both, the payoff for cooperation had diminished as it became clear that their counterpart wasn’t agreeing to key conditions.
- Market and/or economic weakness could change the game: In 4Q18, we believe that the US administration’s market sensitivity and China’s short-term economic exposure played a key role in bringing them to the table amid weakness in global markets and softer data in China. The payoffs for cooperation became clearer and preferable to escalation. A repeat of these pressures could mend this new rift.
We expect this dynamic to pressure risk assets and US bond yields lower. If risk markets don’t drive cooperation soon, escalation will likely cause enough economic erosion to move the markets before long. Consider the impacts of further escalation laid out by our economists in their midyear outlook. A three-to-four month extension of current tariffs could dampen growth in China and the US by 20bp and 30bp, respectively, barely avoiding recession. A longer period of tension, including fresh tariffs on ~US$300 billion of remaining China exports to the US, puts 100bp of global growth at risk and pushes the Fed into repeated cuts. Neither of these outcomes is in the price, in our view, and recent conversations with investors suggest that they under-appreciate the downside impact of such scenarios.
Where could we be wrong? Perhaps the US and China will follow the path lauded by game theorists and marriage counselors alike – communication! Given domestic politics and negotiating stances, we think that it will take weak markets or fundamentals to pry open a channel. Still, any news of fresh, substantive dialogue between the countries should be seen as a positive.
I tend to agree. Right now markets are holding up because bond markets are pricing bad news which, in turn, gives equities hope of good news. Paradoxically this prevents the very outcome equities are betting on: cessation of trade hostilities.