<p>Trade tensions between the US and China has ratcheted up a notch last week, resulting in a possible trade war. Whether a full-blown trade war will happen depends on a game of chicken between both parties. We discuss the possible scenarios that may emerge.</p><p><strong><span style="text-decoration: underline;">1</span><span style="text-decoration: underline;">. Diplomatic resolution</span></strong></p><p>This is the most optimistic scenario where the US and China agree to an amicable trade resolutions. During an interview over the weekend, US Treasury Secretary Mnuchin expressed optimism that an agreement with China could be reached. Any signs of a diplomatic resolution is a positive outcome and will lead to market recovery.  </p><p>While this is the most probable outcome, we do not expect the diplomatic resolution to arrive quickly. Full details of the US trade tariffs on Chinese companies and investments are only to be revealed within 60 days. This provides for negotiations between representatives from US and China. So, there will likely be ongoing posturing from both sides so as to gain an upper hand in the negotiations. The resolution will not be speedy and we expect the overhang from trade war could weigh on the markets.</p><p><strong>Probability: 50%</strong></p><p><strong>Economic implications: Markets to recover from recent correction</strong></p><p><strong><span style="text-decoration: underline;">2</span><span style="text-decoration: underline;">. Tic-for-tac trade war</span></strong></p><p>The US fired the first salvo when President Trump announced a 25% tariff on steel imports and 10% on aluminum. Trade tension was further escalated last week when Trump announced the possible tariffs on China totalling at least US$50bn.</p><p>China has responded that it is “absolutely not afraid of a trade war”. It has imposedUS$3bn tariffs on US imports in response to the steel and aluminium tax. A list of potential tariffs on other US goods are also drawn up. Further, China threatened the possibility of scaling back purchases of US Treasuries and this could be a trigger point for a steep rise in US interest rates.</p><p>This worst case scenario represents a lose-lose proposition for both the US and China. OECD estimates that global GDP would dropped by 1-1.5% with a permanent 10% rise in trade costs. A trade war is equivalent to a war on market and will be unhealthy for the economy.</p><p><strong>Probability: 30%</strong></p><p><strong>Economic implications: Markets to correct further and enter into a bear market</strong></p><p><strong><span style="text-decoration: underline;">3. The bully wins</span></strong></p><p>The US is acting like the bad guy. Trump tweeted that “trade wars are good, and easy to win”. He is unafraid of hurting the ties with other trading partners. The motivation for trade tariffs is to reduce the massive trade deficit with China amounting to US$375bn. He is playing tough as China relies on exports for its economic growth.</p><p>On the other hand, China is acting like the good guy and have only responded with a minor response of U$3bn of tariffs. They are only prepared to retaliate based on the extent of US trade tariffs. So, they are just the defender and not the aggressor.</p><p>We do not expect this situation to happen. China President Xi has cemented his position as one of the most powerful leader after the recent National People’s Congress. It is unlikely he will back down from unprovoked threats. It is unfavourable to his image if he succumb easily to Trump.  </p><p><strong>Probability: 20%</strong></p><p><strong>Economic implications: US market to rally</strong></p><p>Markets are moving towards the lower end of this consolidation phase. We previously highlight the possibility of a contagion effect should a full-blown trade war happens. The break of S&amp;P 500 Index below 2550 will be a strong indication of a contagion impact. Another risk factor is the tightening interbank conditions with the climb of LIBOR to decade highs. Market conditions in the coming weeks will likely be rocky and we advise investors to stay nimble.</p><p><strong>Edmund Chan, CFA</strong></p>