Tariff War Renewed? How U.S.-China Trade Talks Could Play Out

(Bloomberg) -- President Donald Trump’s latest trade gamble has set the stage for a tense round of negotiations this week between the U.S. and China that will have markets on edge.

Trump’s unpredictability was on full display on Sunday, when he took to Twitter to abruptly announce he’s increasing tariffs on Chinese goods. The U.S. says that threat was prompted by Beijing reneging over the past week on some key commitments it made during the talks.

Whether the world’s two-largest economies will sink deeper into their trade conflict may depend on negotiations Thursday and Friday, when a Chinese delegation led by Vice Premier Liu He will visit Washington.

The hawkish turn by the U.S. has forced investors, many of whom were expecting a deal soon, to adjust their expectations. The S&P 500 Index has fallen more than 2 percent since Trump’s tweet.

“A trade deal had been priced into markets, and now we are living through the fallout of altered expectations, so it wouldn’t be surprising to see continued volatility,” said Kristina Hooper, chief global market strategist for Invesco Ltd. “We’re going to see both sides playing a game of chicken.”

Here are some of the possible outcomes from this week’s negotiations:

Tariffs Rise, Talks Continue

U.S. Trade Representative Robert Lighthizer said tariffs on $200 billion in Chinese imports will increase to 25 percent from 10 percent at 12:01 a.m. on Friday. He also indicated the U.S. wants to keep talking.

The Chinese are preparing their own retaliatory duties on U.S. imports should Trump carry out his threat, according to people familiar on the matter. But they, too, are staying at the table.

It’s an awkward equilibrium, but it may just hold. Neither country wants a long, bruising trade war that undermines growth. The incentive to reach a deal grows stronger by the day for Trump, who’s seeking re-election in November 2020.

“Both sides would walk away angry” if tariffs escalate this week, said Clark Packard, trade-policy counsel at the R Street Institute, a think tank in Washington. “But these two countries are the largest economies in the world. After a cooling-off period, they’ll come back to the table.”

Tariffs Rise, Talks Collapse

The stakes are arguably higher than ever as both countries prepare to slap more tariffs on each other.

In an all-out trade-war scenario, annual gross-domestic product may shrink by as much as 0.6 percent in the U.S. and by 1.5 percent in China, according to the International Monetary Fund.

“My most likely scenario is that there’s no final resolution, not for some time,” said Chris Rupkey, chief financial economist at MUFG Union Bank NA. “They’re talking about changing the way another country is doing business. It’s like another country telling the U.S. to stop being capitalist.”

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Tariffs Delayed

Tariffs have been on hold since Dec. 1, when Trump and Xi agreed to a truce to give their officials time to work out an agreement. Before then, the two nations had imposed duties on $360 billion of each other’s products.

The truce, as well as a dovish shift by central banks, has driven a surge in U.S. stocks. Trump will be reluctant to see the rally end. If talks take a promising turn, he may still hold off on a tariff hike.

“This is something you have to take week by week,” said Ed Mills, managing director of Washington policy at Raymond James & Associates Inc. “Our base case for this week is that they find a way to delay the tariffs.”

Deal In Principle

Before threatening to hike tariffs, Trump expressed optimism about the prospect of a deal. A preliminary agreement could come together quickly if Trump chooses to endorse it, perhaps after speaking by phone with his Chinese counterpart Xi Jinping.

The outlines of a deal have been apparent for months. It would likely feature a major increase in Chinese purchases of American goods such as soybeans and aircraft. Beijing would probably commit to shoring up protection for U.S. intellectual property, and refraining from devaluing its currency. All but certain: both sides will tout any pact as a victory. The biggest question left unanswered is whether the existing tariffs will stay in place.

But any preliminary accord would probably require final approval by Trump and Xi at a face-to-face summit. Even after a deal is signed, it could take years to see it succeed in correcting the trade imbalance. The threat of renewed hostilities won’t soon fade.

“The larger question is: can you get a deal, and can that deal stick? That’s where we’ve always been skeptical,” said Mills of Raymond James.