Stocks turned sharply lower yesterday as noise from Washington suggested trade negotiators for both the U.S. and China were taking hard line stances that mitigated the possibility of an interim deal to calm to tariff wars.

Intraday comments from Fed Chair Jerome Powell that suggested ongoing monetary accommodation helped lift stocks momentarily, but trade worries ended up dominating trading and equities closed at their lowest level of the day.

The press spends a lot of time trying to decipher Donald Trump’s attitude toward trade. Listening to his words appears to be a fruitless effort. In an effort to create a bit of negotiating chaos, Mr. Trump plays good cop and bad cop himself. One day, especially after the stock market starts to swoon, he delivers conciliatory messages. On other days, he tries to present a hard line. All the chatter in front of any deal is meaningless. Both sides know where each other stands and both sides to date have been reluctant to give ground and move toward the center. That isn’t uncommon in negotiations, but how this battle ends remains uncertain. The standard line is that Trump wants a deal reasonably soon to help avoid any possibility of recession in 2019. If he takes the big step on invoking tariffs on most of China’s exports of consumer goods in December, there will be a clear negative impact on our economy. Of course, there will be an impact on China as well, which could be more severe than the impact on ours. But it is the state of our economy next fall that has a major bearing on the outcome of the 2020 Presidential election. For that reason alone, most pundits predict that Trump will somehow find a way to delay or defer the December wave of new tariffs.

But let’s look at it from the Chinese standpoint. Let me start by not making an assumption on who China might favor in the 2020 election. Long term, this escalating economic battle will transcend the Trump presidency whether it be four years or eight years. China’s 2025 economic plan is to reach economic and technological parity with the developed world by then at the latest. To do so, China has a big road to climb. Despite all of its economic growth to date, China has succeeded by being efficient more than being technologically innovative. It knows it will lose some of its competitive advantage to its Asian neighbors as it moves toward becoming a developed nation. Rising standards of living mean higher wages and higher costs. To offset this, China must innovate and raise its level of technological expertise. To do this sooner rather than later, China has invoked forced technology transfers among other steps.

China also knows that deal or no deal, U.S. companies, sensing a heightened competitiveness between the two countries, will work to diversify their supply chains with or without a deal. It is hard to believe that current trade negotiations will be the end of economic conflict between the two nations. China will be both our economic and political adversary for many years to come. From the end of the cold war and the fall of communism in the late 1980s until recently, the U.S. has been the dominating world power without strong direct competition. While Russia and others in the Middle East remain political and military threats, it is clear that the 800-pound gorilla for years to come will be China. When we backed out of the Trans-Pacific Partnership (TPP), countries along the Pacific Rim looked to China to fill the gaps. China’s silk road game plan is to provide economic support that strengthens trade relationships all around the world. And that includes China and the Western Hemisphere.

Undoubtedly, China will feel the pain of further American tariffs. It doesn’t want to see more tariffs implemented later this month or in December. A weaker economy is bad for Chinese political leaders just as it is for President Trump. But President Xi doesn’t face an election next year. China can afford to make Trump squirm for several more months. Perhaps it is in their interests to better understand what relationship they might have with the Democratic candidate that emerges as Trump’s opponent. While any president will view China as an economic and political adversary, each will employ different tactics. Joe Biden would seem to take positions similar to Barack Obama. Elizabeth Warren’s stances are less fully developed. Certainly, she wants a level playing field and will take tough stances, but it isn’t clear how she stands on tariffs. Perhaps, if the pain of tariffs increases over the coming months, she will suggest her own alternatives that play to her base and the overall public.

Thus, I come to the following conclusions without having any knowledge of how trade talks might progress in the coming weeks.

1. China would like to avoid more tariffs in the short run if it can do so without slowing its ultimate path to economic and technological parity. If it can strike an interim, good-faith deal by committing to buy a lot of soybeans and planes, it will grab the opportunity to buy some time and defer the hard issues.
2. China might even accept some changes in ground rules that won’t seriously slow its progress toward its 2025 goals. But in no way will it simply accept what it views as a one-sided deal that allows the U.S. to set both the rules and the enforcement penalties.
3. Trump has more to lose if escalating tariffs lead to recession worldwide. China knows this and, therefore, might let Trump squirm a bit to see if he is more willing to give ground in the coming months to make a deal that China can accept that will allow the U.S. to avoid a recession.
4. Despite all of the above, U.S. companies will diversify supply chains across all of Asia. That process will take many years and it will occur regardless of the outcome of trade negotiations.
5. Despite all the rhetoric back and forth, as the two largest economic powers, the U.S. and China are interlocked in ways that cannot be decoupled. We both need each other. It has taken 25 years to get to where we are today, and that can’t be unwound whether there is a trade deal near term or not.

None of what I said changes the likelihood of some sort of first step deal in the coming weeks. That may or may not happen. A fully encompassing deal will take much longer, perhaps years. As in any major negotiation, a lot depends on the respect and trust the two sides have for each other. Can Trump and Xi make a big deal? I have no idea. Trump persistently states that the two have great respect for each other, but we don’t really know. Can Biden or Warren make a better deal? That, too, is an open question. What we do know, in the short run, is that tariff escalation is painful and could get more painful. It is Trump’s weapon of choice. He uses it everywhere as a threat and, as was the case with Mexico and migrants recently, there are times tariff threats prove effective. But they don’t always work. We will find out soon whether that is the case or not with China.

Wall Street hates uncertainty and clearly there is plenty of it today as more tariff deadlines approach. Markets are assuming that somehow, the December tariff increases don’t happen. Clearly, if they do, Trump will be increasing economic pain on the U.S. at an inopportune time. But he needs some give from China to allow him to pull back. The real question, therefore, is whether it is in China’s long-term interest to reach a short-term deal now or let Trump squirm a bit to see whether they can extract a better deal. In the meantime, Wall Street will continue to go through a period of volatility, at least until the resolution of the December tariff threat is resolved. Obviously, should they be implemented, the outlook for stocks would deteriorate. That remains an if. Hopefully, we will learn more over the next week.

Today, Sean Lennon, the only child of John Lennon and Yoko Ono, is 44. It also happens to be the birthday of John Lennon, who would have been 79 today.

James M. Meyer, CFA 610-260-2220

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