While there is low probability the tariff dispute between the United States and China will erupt into a full-scale trade war, the markets are struggling to price the risks.

President Trump proposed tariffs on an estimated $50 billion in imports from China, weeks after slapping tariffs on aluminum, steel, and washing machines. The tariffs follow an investigation by the administration into the theft of intellectual property from U.S companies. In April, China, the world’s second-largest economy, retaliated by imposing tariffs on U.S. imports worth around $3 billion. China also launched a World Trade Organization complaint against the U.S. action, and while it could be withdrawn, this machinery is now in motion.

Is it all just bluster, or is there a real threat?

However, it should be remembered that the major tariffs on both sides remain proposals. The U.S. tariffs are going through a period of public comment and will probably not take effect until June. The Chinese tariffs are not constrained by a legal timeline, but they are likely to be imposed within hours of the U.S. tariffs. A full-scale trade war, which would produce significant negative economic effects and lead to a very bad outcome, has low probability, in my view. However, markets struggle to price events that have a low probability but a high impact. So how worried should we be about trade? Is it all just bluster, or is there a real threat? A sitzkrieg or a real trade war?

The Korea deal offers clues

We are noticing a clear pattern in Trump’s trade policies. Tariffs on steel and aluminum were imposed but promptly relaxed for “allies.” The trade agreement between South Korea and the United States (KORUS) was denounced by Trump as “disastrous” and then was renegotiated. Under the revised agreement, U.S. auto companies saw their annual quotas in the Korean market increased from 25,000 to 50,000 vehicles; lost in the headlines was the fact that no U.S. company currently sells more than 10,000. Korea agreed to restrict its steel exports to the U.S. to about 70% of the volume of recent years and agreed to accept United States testing standards on auto parts. A prohibitive tariff on United States imports of Korean pickup trucks that had been set to expire in 2021 will now run for a further decade. That’s it. Pretty impressive, no? It was enough to transform the deal into one Trump described as “great.”

Trump wants headlines but lacks a grasp of details or even of how policy works, so he ends up accepting whatever deal his team can strike. There is obviously a good chance that this pattern will hold in the case of China. But there are two reasons for caution. First, his administration’s makeup seems to be changing. The new foreign policy team is much more hawkish; John Bolton is a neo-conservative who has advocated military action against North Korea and Iran. Geopolitical risks, especially with North Korea, may re-emerge under a new foreign policy team.

The second reason is that the relationship with China is much more complex. China is bigger, a more serious player. It is run by nationalists, and its leaders understand the country’s strategic interests in a way that the current U.S. administration does not. The stakes are a lot higher. Moreover, Trump and some of his recently empowered advisors, notably Peter Navarro, seem to focus a lot more on China than they do on other countries.

Volatile global markets

You can see how this has been playing out in the early stages of the Sino-U.S. trade spat. In reaction to the steel and aluminum tariffs, China imposed tariffs on a range of U.S. exports, including pork and dried fruit (a possibility we noted in last month’s edition). The Chinese tariffs were designed to match the U.S. move, but not escalate matters further, and were accompanied by official statements suggesting negotiations. With the latest round of U.S. tariffs, China responded with tariffs on soybeans. This came just as U.S. farmers were making their planting plans for the coming season, and farmers are reliable Republican voters. The Chinese were clearly signaling their willingness to raise the stakes and rely on the U.S. political system to isolate Trump.

Financial markets, especially equity markets, were quite volatile as this dance was proceeding. They fell as fears of a trade war rose and recovered on hopes these measures and countermeasures were just steps in an elaborate negotiation that would eventually result in a deal that, like KORUS and probably the North American Free Trade Agreement, would result in no major destructive changes to the trading regime and the economic outlook. But the dancing to and fro has been messy. Trump is currently in a difficult position. If he wants to be taken seriously by the Chinese, it doesn’t help if U.S. markets treat his comments as empty rhetoric. He has to increase his bet, even if he knows he’s going to fold eventually. This is the problem of making threats credible.

No power imbalance

Which way will this go? We are optimistic the world’s two largest economies will resolve differences through negotiations. But this could drag on. The stakes and the conviction on both sides are high, and there is no obvious imbalance in negotiating strength. Some tariffs are likely to take effect this year. However, we may not get an actual trade deal until later. There are minor risks to the economy, and they are asymmetric. The chance that something bad happens to global trade flows is much greater than the chance China will open its markets to U.S. firms. If the drama goes on, even if there is eventually a benign outcome, it’s hard to see how the recent stresses in the equity market will avoid spreading to financial markets more broadly. If Trump’s threats don’t disturb asset markets, why should the Chinese pay attention?

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While there is low probability the tariff dispute between the United States and China will erupt into a full-scale trade war, the markets are struggling to grasp the implications of the measures.