Options Market Suggests China Has Edge in Trade War

(Bloomberg Opinion) -- U.S. President Donald Trump under-estimated China President Xi Jinping’s resolve when he raised tariffs on about $200 billion of imports from China to 25 percent from 10 percent, warning his counterpart not to respond in kind. That advice was ignored.

Trump’s action and China’s response – imposing duties on about $60 billion of U.S. exports to take the total of affected products to $110 billion – led to a 2.41 percent slide in the S&P 500 on May 13, the biggest drop in the index since Jan. 3. In combination with a drop in the yield on 10-year Treasuries to about their lowest since 2017, the clear conclusion is that investors are nervous about the impact that the latest tit-for-tat salvos in the long-running trade dispute will have on U.S. economic growth.

Investors are right to be nervous. Even though tariffs hurt China more, due to its $379 billion trade surplus with the U.S. in 2018, it doesn’t necessarily mean Beijing is hamstrung. It may actually be able to ride out the storm longer than many think.

Options prices, which provide important insights into shifting near-term market risks, suggest that Trump may have picked a fight he has a diminishing chance of winning. For the S&P 500 and other U.S. equities, the ratio of the expected upside (as implied by call option prices) over the expected downside (gleaned from put prices) has declined sharply. As a result, U.S. equities are among the least attractive of all developed-market stocks and less attractive than both Shanghai Stock Exchange A-Shares and Hong Kong Stock Exchange H-Shares.

From the start of the month through May 10, the upside to downside ratio declined by 5.5% percent to 0.98 for A-Shares and 0.96 for the Hang Seng, which includes a significant proportion of H-Shares. Over the same period, the ratio for the S&P 500 slid 13% to 0.89. In other words, option market prices have shifted and now indicate that market participants’ consensus view is that Chinese equities are a potentially better buy than U.S. stocks.

This may be partly because China has several counter measures available to help offset any damage from the trade battle that the U.S. lacks. Moreover, if Xi is politically motivated not to accede to U.S. demands, it could mean China may drag its feet in reaching a deal because the costs to defer might be quite low. Rather, the urgency may be on U.S. officials, because Trump is laser focused on an immovable deadline: the 2020 presidential election. 

China has the option to employ fiscal stimulus to help overcome the potential economic drag caused by trade tariffs. Bloomberg News reported May 16 that China’s central and local authorities have $3.65 trillion in unspent budget – the equivalent of Germany’s entire annual economic output – to unleash on public projects if needed. A large spending campaign would be a short-term boost to the second-biggest economy. Such stimulus is virtually impossible in the U.S. as a way to contain any short-term fallout from tariffs because, in addition to taking a long time to undertake such programs, it is unlikely that the Democrat-controlled House of Representatives will sanction further spending on infrastructure projects on concern that it would benefit Trump’s re-election bid.

It’s a not dissimilar picture on the monetary policy front. As New York Federal Reserve Bank President John Williams said on Bloomberg TV on May 14, tariffs are inflationary, something that is exacerbated when the opposing currency, the yuan, doesn’t freely trade, meaning it won’t decline to fully adjust for the tariffs (although it has weakened since the trade dispute began). When combined with generationally low U.S. unemployment, such inflationary risk limits the Federal Reserve’s ability to offset the impact of duties through monetary easing. Despite persistent pressure from Trump to lower rates, the Fed reiterated this week that it will continue to take a patient, data-driven approach to assessing inflation risks.

China doesn’t face such limitations. U.S. exports to China rank third behind Japan and South Korea, meaning American imports have less influence on Chinese inflation than goods moving in the other direction. That gives the People’s Bank of China more scope to run with monetary stimulus in addition to fiscal spending.

In his bid for a second term, Trump wants to be seen as the guy who brought China to book for long-standing unfair trade practices such as intellectual property theft and the forced sharing of technology. He also needs the S&P 500 to continue to rise. Unfortunately, those two goals may be incompatible. By escalating the trade dispute, Trump looks tough to his base, but he also creates headwinds for U.S. stocks.

China knows this. Beijing can prolong the trade battle, perhaps making it more likely that the U.S. will eventually be the one making concessions. Under this scenario, patience is a virtue for China. In addition to its monetary and fiscal weapons, China may also want -- or need -- to lower its purchases and holdings of U.S. Treasuries to finance its stimulus program. That would be an additional blow to the U.S., hindering its ability to finance its debt and consumption.

The upside to a long battle with China is that it makes it increasingly unlikely that Trump will risk extending his trade spats to partners in other blocs, as he implied he might do recently via tweets threatening tariffs on European automakers. This is consistent with options signals showing greater upside potential than downside risk for equities in large export economies such as Europe and Japan.

So while on the surface higher tariffs on more goods for a longer period may hurt China more than the U.S. in the short term, it shouldn’t be a surprise if the trade battle rages on or, over the long run, China ultimately outguns the U.S. 

To contact the editor responsible for this story: Robert Burgess at bburgess@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Myron Scholes, who received the Nobel Prize in Economic Sciences in 1997, is the chief investment strategist at Janus Henderson Investors.

Ash Alankar is the global head of asset allocation and risk management at Janus Henderson Investors.

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