Thread by @jsmian

For all the attention it receives, the US-China trade war is hardly consequential. Since President Trump first signed a memorandum to impose tariffs on Chinese products on March 22, 2018, the S&P 500 is actually up 8% and the MSCI World Index is flat.

As we said at the time, trade war is a micro, rather than macro threat. Any trade protectionism will not have a lasting impact on either the US or Chinese economy but will much more severely influence the share prices of targeted companies, currencies and commodities.

Global trade overall is not at a risk of disruption or even imminent disintegration. US-China trade is about 3% of global trade and automobile trade globally is about 8%. Global trade volumes grew 3% in 2018 and WTO expects 2.6% growth this year.

While the protectionist threat to cross-border supply chains is on the rise, supply chains cannot be so quickly unraveled or rebuilt. More than 60% of world trade is in intermediate goods, with China a major trade hub interlinking the supply chains of large multinational firms.

In the first half of 2019, the US trade deficit has widened 7.9% from a year earlier to $316 billion. If the Trump administration fails to cut the trade deficit, as we expect, the offshore supply of dollars— the monetary base for global trade and reserves—will not be curtailed.

The US now earns $69 billion in tariff revenues (90% from China), but with only limited effect on the trade balance between both countries. US imports from China have fallen significantly but US exports to China have also declined after China imposed retaliatory tariffs.

China is the largest trading nation for over 130 countries. China's drop in exports to the US have also been more than offset by an increase in exports to the rest of the world.

No doubt the damage to the US-China relationship has been considerable, but both countries’ interests are too intertwined for the time being to keep up the trade war. We still think a trade compromise is reached this year.

China’s biggest weakness is its reliance on US technology imports. The value of China’s semiconductor imports exceeds its oil imports. The US can choke Beijing’s technological ambitions by halting the supply of semis.

What every first term president wants is a second term. Trump’s tariffs are hurting his chances for re-election in key battleground states. Farmer bankruptcies in six Midwest states rose 30% in 2018 and the jobless rate is rising in five states which went to Trump in 2016.

Apart from winning a second term, what Trump wants most of all is a weaker dollar. But his “power-based” bargaining is backfiring, as the tariffs are pushing the dollar higher. The yuan is down 12% against the dollar since March 2018, when the trade war began.

Of course, what worries investors is that the US-China trade conflict is taking a more severe turn and if China lets its currency go, it will trigger a major deflationary shock and push the world closer to a tipping point.

We are far more sanguine. There are many reasons as to why a large-scale yuan devaluation does not make economic sense for China.

First, China is no longer an export-led economy. Exports as a share of GDP peaked in 2006 at 35% and stand at 18% today. Over the past five years, the average net export contribution to China’s GDP growth was negative 1.3%.

Second, a much weaker yuan would act as a tax on consumption and reverse much of the progress policy makers have made in economic rebalancing thus far. Real per capital disposable income is up 6.5% in 2019, close to the 6.6% pace a year ago.

Third, China’s main problem of excess capacity (and associated debt) in the northeastern rustbelt would not suddenly be cured by a devaluation. Rather commodity prices would be hit hard and lead to goods price deflation (PPI), only making the problem worse.

Also, as @Brad_Setser notes, “China historically hasn’t managed its economy by letting prices go where they want. Stepping back from any currency management would be a huge shift in China’s own broader economic management. It isn’t clear China is willing to take that plunge.”

That said, Beijing is less committed to keeping yuan steady after the breakdown of trade talks. If the yuan keeps dropping, Trump’s tariffs lose potency, only acting as a tax on US consumer. Which makes us wonder, could China’s currency move be the closing salvo in the trade war?

US and China will be locked for years in a race for global leadership in critical new technologies and industries that are needed for long-term competition, which includes the 5G rollout worldwide. But the most likely present scenario is still a provisional truce.

The real flashpoint in US-China relations is not a trade war or even a tech war. The economic decoupling is a multi-decade theme and markets will soon become desensitized to it. The biggest geopolitical threat to markets is, in fact, a conflict over Taiwan. More on that later.