The Stock Market and Trading with China

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Financial pages note diligently, seemingly daily, how stock prices rise and fall with the prospects of a U.S.-China trade deal.  When hopes dim, prices fall, and when they improve, prices surge.  Partly this reflects investors’ constant desire for peace and business-as-usual. They want the uncertainty to lift and to be able to plan around doing business with China and seeing the potential profits therein.  But that is far from the whole story.  Markets – along with the Trump administration and many in Congress (including Democrats) – would also like to see China end its unfair business practices, its outright theft of technologies, and its regulatory biases against American firms.  And as much as they all want such reform, they also fear the tariff weapon that Trump has deployed to achieve those ends.  All these considerations lie behind the market’s response to these tense negotiations.

Let’s look at each of these drivers:

The ever-present discomfort with uncertainty among investors dominates most of the media coverage. This is as it should be, because uncertainty is the most obvious trigger that moves the market.  Before President Trump decided to take on Beijing, everyone knew where they stood. Matters may not have been as people would have liked, but they understood, at least roughly, what to expect and they could make their investment plans on that basis.  But now matters are up in the air; no one can accurately predict how things will come out.  When negotiations between the U.S. and China appear to be going well, the prospect of certainty buoys investors’ hopes and they buy.  When negotiations appear to falter, they pull back, and market prices reflect that lack of support.

Aside from planning, investors want trade to resume and the profits that flow from it. Though China acted in ways that the U.S. didn’t like, the trade provided a reliable flow of inexpensive consumer goods and materials for American consumers and American industry — for instance, the rare earth elements that are essential for battery technology. This trade flow enhanced America’s general growth prospects as well as corporate profitability.  China trade also enhanced growth in Europe and elsewhere in Asia, which in turn further enhanced the business prospects of American companies. Investors love nothing that interrupts this pattern.

Market participants also fear tariffs.  They have learned from textbooks and from bitter, real world experience that tariffs and subsidies distort markets and make business less efficient and thus, on balance, less profitable.  We all know that firms favored by tariffs and subsidies can benefit from them greatly, but only at the expense of other businesses.  On net, the business community generally and the American and other economies lose out.  There is also the historical warning from the last time the U.S. turned to tariffs with the Smoot-Hawley Act, passed in 1930 during the Great Depression.  Those tariffs hurt American consumers and businesses by raising the cost of much of what they bought, and they hurt American exports when other countries retaliated with tariffs of their own.  There is ample evidence that those tariffs turned what might have been a severe recession in the early 1930s into the Great Depression.   The Trump tariffs are nowhere near as extensive or severe as Smoot-Hawley, but the warning is there.

Yet anger at Chinese business practices keeps investors rooting for some success in the Trump administration’s efforts.  The business community, both here and in the rest of the world, have long complained about how China subsidizes its industry and about its local content rules that go beyond those of any other major nation in insisting that contractors, foreign and domestic, use domestically produced materials in China, regardless of cost or quality.  Also, in the past, China has manipulated its currency to give its industry price advantages over American, European, and Japanese businesses.  Beijing turns a blind eye when its firms, including government-owned enterprises, steal technologies and business secrets from foreign firms, including American companies.  Perhaps most irritating of all is Beijing’s insistence that any foreign firm doing business in China must have a Chinese partner and must reveal to that partner its technological and commercial secrets.  U.S. presidents going back at least to Bill Clinton have complained about these practices and have received assurances from China’s leadership that they will stop (most prominently, assurances given to President Obama during his second term).  But Beijing has always reneged.  There is hope that the current trade negotiations will exact something more substantive.

With this as background, we can identify four possibilities and the market’s likely reaction in each, though I am not foolish enough to attach a precise number to any one of them:

1. Best Case: The United States prevails in the negotiations.  Beijing offers acceptable assurances that China will alter its business practices.  The tariffs are removed, and with it the fear of where the continuation of tariffs might have led.  Trade resumes, and so do the prospects of global growth.  American businesses can plan again in a more favorable environment. Stock prices would not only surge on the news but the advance would likely continue with the prospect of improved commercial profitability.
2. Second Best Case: Washington accepts something akin to China’s old assurances, lifts the tariffs, and trade resumes.  This possibility would have all the positives of the best case above and the market would indeed lift, but not nearly as much as in the best case, because investors and business people would have no real confidence that China would change its business practices.
3. Pretty Bad Case: Trump backs down, lifts the tariffs, but gets no deal from China to speak of.  This possibility would have a lot of the positives of the two better cases above, but there would be no hope that China would change its business practices and everyone would know that in the future Washington would be negotiating from a position of weakness.  The markets might briefly surge on the positives, but such a rally would have no staying power and might even reverse as the longer-term negatives became apparent.
4. Worst Case: The battle goes on with no sign of resolution.  This prospect would maintain all the tariffs and the fears associated with them.  It would offer not even a hope that that the Chinese would change their business practices, and it would signal that the interruptions and uncertainties in trade would last indefinitely.  The market would sink on this news and it would continue to lose ground.