Why the US-China trade war won’t last

The United States and China don’t just coexist. Their massive economies are deeply intertwined in ways that make the intensifying trade war unsustainable.

China’s booming middle class is a critical growth engine for Boeing (BA), Apple, Nike (NKE) and other American brands. China is expected to keep growing in importance as a buyer. And America’s insatiable appetite for cheap goods has created a Chinese factory juggernaut that employs millions of workers.

The world’s two largest economies are each other’s biggest trading partners. Nearly $700 billion in goods were sent between China and the United States in 2018 alone. And with $1.1 trillion of Treasuries, China is America’s largest foreign creditor.

The United States has legitimate complaints about China’s trading practices, and persuading China to open its market to American sellers is an important goal now and for the future.

But China and America need one another. The tit-for-tat tariff battle is threatening one of the world’s vital economic relationships — and because of their size, the global economy. At a time when the two nations should be forging rules for the next 20 years, they are pointing a gun at one another.

“We have to learn how to live with each other,” said Keith Lerner, chief market strategist at SunTrust.

For good reason, the breakdown of the US-China relationship is spooking investors and economists alike.

The Dow plunged 617 points, or 2.4%, on Monday after China retaliated against tariffs announced last week. Beijing vowed to impose higher levies on $60 billion of US goods, everything from cotton and aircraft parts to wine and machinery.

“The risk of a full-blown trade war has materially increased,” Tao Wang, chief China economist at UBS, wrote in a report to clients on Monday.

‘Monstrous’ risk

Tariffs are the weapons of choice as both sides attempt to improve their negotiating leverage. Consumers and businesses find themselves caught in the crossfire. The levies will increase costs, muddle supply chains and drive up debilitating uncertainty.

UBS cut its 2019 GDP growth forecast for China from 6.4% to 6.2%. While Beijing will try to soften the blow with stimulus, UBS said growth could slip below 6% in 2019 and 2020 if the trade war deepens.

FILE PHOTO: Containers are seen at the Yangshan Deep Water Port in Shanghai, China April 24, 2018. REUTERS/Aly Song/File Photo

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“The risk is monstrous. It’s very troubling,” said David Kotok, chairman and chief investment officer at Cumberland Advisors.

The interconnectedness of China and the United States has been driven in part by the millions of people in China that have been lifted out of poverty.

“You have an expanding middle class wealth effect,” said Kotok, who also serves as director of the Global Interdependence Center, an organization advocating for the expansion of free trade.

Sneakers, iPhones and LNG

China’s customers are using their newfound wealth to buy more cars, iPhones and sneakers. That’s a massive growth opportunity for General Motors (GM), Apple and Nike.

“A lot of China’s rising middle class loves US brands,” said SunTrust’s Lerner.

And China’s consumers are flying more, making the country Boeing’s most important export market. But there’s growing fear that Boeing could be used as a bargaining chip in the trade battle.

TOPSHOT - US President Donald Trump (L) and China's President Xi Jinping leave a business leaders event at the Great Hall of the People in Beijing on November 9, 2017. Donald Trump urged Chinese leader Xi Jinping to work "hard" and act fast to help resolve the North Korean nuclear crisis, during their meeting in Beijing on November 9, warning that "time is quickly running out". / AFP PHOTO / Nicolas ASFOURI (Photo credit should read NICOLAS ASFOURI/AFP/Getty Images)

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The United States sent $120.3 billion of goods to China in 2018, making it the No. 3 market behind only Canada and Mexico, according to the US Census Bureau.

America’s energy boom makes it a great fit to help solve China’s pollution problem. The United States is the world’s fastest exporter of liquefied natural gas, a cleaner fuel that can help countries transition away from coal.

However, China’s purchases of LNG have slowed during the trade war. And that trend may continue because Beijing on Monday raised tariffs on LNG from 10% to 25%.

China’s transition to a consumer-led economy creates massive opportunities for foreign companies, especially US ones.

By 2027, rapid income growth will lift about 180 million low- and lower-middle-income households to a higher income bracket, according to a study by Bain & Co.

Much of the focus during the trade war has been about the goods exchanged between both nations. But American businesses are already cashing in by providing services to China’s masses — and they’re eager to sell even more as China matures.

While the United States has long had a goods deficit with China, it ran a services surplus of $40.5 billion in 2018. Leading services exports to China include travel, computer software and trademarks, according to the Office of the US Trade Representative.

China has long been a tantalizing place for American banks and investment firms. Financial services companies, hungry to lend to businesses and provide investment banking expertise, are pushing for greater access to China’s underserved market.

China reliant on American consumers

At the same time, American companies have relied on China as a source of relatively affordable labor and parts. Retailers import merchandise from China. Apple (AAPL) imports iPhones that are assembled in China by manufacturers like Foxconn.

All told, the United States imported $539.5 billion of goods from China in 2018, according to the Census Bureau.

Those purchases have helped keep China’s factories humming, employing workers whose jobs are now threatened.

“China has become very dependent on exports to the US,” Ed Yardeni, president of Yardeni Research, wrote in a note.

Dumping Treasuries could backfire

China also plays a critical role in financing America’s staggering debt.

With $1.1 trillion of Treasuries, China is the leading foreign creditor. That’s just ahead of Japan and roughly equal to the combined Treasury holdings of Brazil, the United Kingdom, Ireland and Switzerland. Washington uses that debt to fund everything from tax cuts to fighter jets.

A leader in China’s state-run media suggested on Monday that Beijing may try to use Treasuries as a weapon in the trade war — an alarming idea that could rattle global financial markets.

Retired General David Petraeus, chairman of KKR Global Institute, speaks during the Skybridge Alternatives (SALT) conference in Las Vegas, Nevada, U.S., on Wednesday, May 8, 2019. SALT brings together investors, policy experts, politicians and business leaders to network and share ideas to unlock growth opportunities in finance, economics, entrepreneurship, public policy, technology and philanthropy. Photographer: Joe Buglewicz/Bloomberg via Getty Images

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“Many Chinese scholars are discussing the possibility of dumping US Treasuries and how to do it specifically,” tweeted Hu Xijin, the editor-in-chief of China’s Global Times.

Such a move, however, could backfire on China by hurting the value of its own holdings and limiting its access to US dollars, the world’s reserve currency.

“They would be shooting themselves,” said Peter Boockvar, chief investment officer at Bleakley Advisory Group.

Boockvar said it’s more likely that China will continue to allow existing Treasuries to mature without reinvesting them. Last week’s 10-year Treasury auction had the weakest demand since 2009, according to Boockvar.

Repairing the relationship won’t be easy

Despite concerns over the deepening trade war, many investors at the SALT Conference in Las Vegas last week applauded President Donald Trump for confronting China on its unfair trade practices.

“China got used to having this advantage,” Michael Novogratz, founder and CEO of crypto merchant bank Galaxy Digital, told CNN Business. “You needed to take the punch bowl away.”

Optimists hope that the pain from the trade war — for both sides — will limit its duration. Many economists expect Washington and Beijing will eventually come to their senses and reach a trade agreement.

“Trade wars are simply bad economics,” David Kelly, chief global strategist at JPMorgan Funds, wrote in a report to clients on Monday. “The silver lining is that they are so clearly detrimental to the American economy and American business that, despite current concerns, they are unlikely to be a long-term feature of our financial landscape.”

But some worry the damage to the US-China relationship may be hard to undo.

“Even if the whole thing settled today by miracle, there would be no trust for a generation,” said Kotok.