US-China Trade: Three trade war scenarios – ‘no deal’ now our baseline

• US-China trade relations have clearly deteriorated and our baseline scenario is now that the two countries will not reach a deal this side of the 2020 election. In this scenario, we see two possible paths. One is no deal but a status quo without much further escalation (35% probability). The other is an all-out economic war in which we see a significant escalation of the trade war (25% probability).

• We also still envision a scenario (40% probability) in which Donald Trump scales back his demands on China to reach a deal in 2020, in which China buys significant amounts of agricultural products. Trump's big headache with respect to the 2020 election is the substantial pain the trade war is inflicting on US farmers. These are decisive voters in key swing states, where his showing in the polls is currently weak.

• Overall, we see a clear increase in downside risks to growth over the coming year. The main restraint on Trump's economic attacks on China is the potential damage to US markets and the economy resulting from Chinese retaliation.

US-China relations reached a new low point this week, with the US designation of China as a ‘currency manipulator'. This followed a sharp move in USD/CNY above 7 as the expected tariff increase on 1 September triggered selling pressure on CNY.

For now at least it seems that both the US and China have thrown in the towel in terms of reaching a trade deal. The gap between them is simply too big to be bridged and the relationship between them on all fronts has eliminated the trust in each other on both sides. Trade talks in Shanghai last week showed no movement on either side of the table. The recent development has left significant uncertainty over where this trade war is heading. When faced with high uncertainty, we believe working with scenarios is normally a good idea. Below we sketch out three potential scenarios for where we could go from here (one can imagine many more but for clarification we stick to three).

Scenario 1 (35%): no deal but not all-out economic war

Generally, we now see a 60% probability that we will not see a deal this side of the election. In this case, we see two possible scenarios. One is a path where the deadlock continues and the rhetoric is still very tough but the status quo is broadly in place with only limited further escalation. US export controls on Huawei stay in place but the US does not increase tariffs on Chinese goods further.

What would be the rationale for such a scenario? First, Trump may reach the conclusion that it is not possible to do a trade deal at all because China is simply not moving enough. China's demand for a total roll-back of tariffs without being willing to write part of the deal into its laws may be too much for him to swallow. China may also simply not want to make a deal. It may have reached the conclusion that it is better off by aiming to weaken Trump's electoral base, hoping to negotiate with a Democratic President on the other side of the election.

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