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The Trade War Escalates, is China really out of Ammunition?

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In a widely anticipated move, the Trump administration announced on Monday afternoon that it would be imposing tariffs on an additional $200B worth of Chinese imports. The tariffs will go into effect on September 24th and will start at 10% and rise to 25% on January 1st, 2019, presumably to mitigate their impact on holiday shoppers in the U.S. who are purchasing Chinese imports.

Approximately half of all Chinese goods imported into the U.S. are now subject to some tariffs and the president made it clear that he was prepared to impose tariffs on an additional $267 billion worth of imports - which would mean virtually all Chinese goods would be subject to some tariffs. He specifically mentioned that any perceived effort on the part of the Chinese to target the American Farming or Manufacturing industries would be grounds for the imposition of additional rounds of tariffs.

Some notable goods were exempted from the proposed list, apparently in response to complaints from high-tech companies like Apple (AAPL - Free Report) and Dell who argued that they are dependent on Chinese imports -especially for parts and supplies that are not readily available domestically.

Predictably, China responded with its own expansion of tariffs on $60B worth of U.S. exports which, when combined with $50B in tariffs imposed earlier this year, now cover basically all U.S. exports to China.

The U.S. equity markets shrugged off the latest shots fired in the trade war with the Dow, S&P 500 and Nasdaq indexes all registering gains of better than 0.5% at midday.

Commerce Secretary Wilbur Ross opined in a television appearance on Tuesday morning that China is now “out of bullets” because they import only about a quarter of the dollar value of goods from the U.S. that they export and have now expanded tariffs to all of the imports.

What Else can China Do?

President Trump has made it clear that his main goal is to force China bask into serious negotiations to reduce the U.S.-China trade deficit and to make it easier for American businesses to expand into Chinese markets without surrendering valuable intellectual property. In a sense, China is in fact out of bullets in that there are no more U.S. goods on which to apply tariffs. That $380 billion trade deficit simply gives the U.S. more opportunities to impose tariffs that China can’t match.

So far, however, China has displayed an intent to retaliate with non-tariff restrictions in trade which would target U.S. industries that depend on either Chinese supplies that go into finished goods sold elsewhere and/or rely on the Chinese market to sell their wares. China still has the ability to inflict significant pain on U.S. companies, though its also expected that any such moves would further damage their own economy as well – an economy which has been slumping of late with Chinese GDP growth off 50 basis points in 2018.

In contrast, the U.S. economy has seen a healthy expansion this year with GDP growth above 4% in the most recent quarter and the expectation for a sustainable growth of 3% for the foreseeable future. With relatively strong ecomomic prospects combined with a hefty trade deficit, it certainly appears that the U.S. has more ammunition to spend in a protracted trade war.

How Long can this Last?

Alibaba (BABA - Free Report) founder Jack Ma predicted on Tuesday that a trade war would be a “mess” that could last up to 20 years and that any resolution would depend on China’s willingness to open their markets.

Unfortunately, China so far has shown no interest in backing down and may instead be digging in for an extended war of attrition. Even if China were to feel more economic pain from a slowdown than the U.S., Chinese president Xi Jinping’s lifetime appointment could give him more ability to withstand an unpopular trade war than the U.S. president - who faces re-election in 2020.

One thing that’s clear is that the trade war will negatively affect thousands of companies and millions of people on both sides of the Pacific, though not everyone will be affected equally. Because of the huge number of moving parts in the equation, it’s difficult to predict with accuracy exactly what those effects will be months or years down the road.

Scott Wine, CEO of Polaris Industries (PII - Free Report) – which had recently been expected to be a beneficiary of the trade war because they source materials and sell finished products primarily inside the U.S. – explained in an interview on CNBC that he was seeing increases in the prices of raw materials, especially steel and aluminum, as domestic producers were quick to raise their prices after the enactment of metals tariffs. His difficult choice now is whether to accept lower gross margins, or to raise retail prices at the possible risk of market share to less expensive competition from jurisdictions that are not subject to the same tariff-induced pricing pressures – especially Japan.

How Does it all End?

It seems clear that the best case scenario for the global economy would be for China to come back to the table and acquiesce to at least some of the Trump administration’s demands in the hopes that we can put the endless retaliation behind us. So far, China has shown no propensity to do so - and of course no one expects Trump to stop hitting back as hard as he can with each new development.

If China can’t see it’s way to back down, it’s entirely conceivable that we could be covering these trade war events for years to come.

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