In brief

• Since the 2018-2019 U.S.-China trade war, China has diversified its export markets, reducing its reliance on the U.S. However, uncertainty looms over the scope, magnitude and timing of potential U.S. tariffs in the coming year.
• To mitigate tariff impacts, China is likely to lean more on fiscal policy than currency depreciation and may choose to negotiate rather than retaliate. A complete decoupling from China is challenging  due to its integral role in global supply chains.
• China's equity market remains largely domestic-focused. Investors should consider defensive and service sectors to navigate escalating tensions, while also exploring select opportunities that could benefit from policy support.

President-elect Trump’s proposed use of tariffs poses a major risk to global markets in 2025. While we will address different aspects of this issue in upcoming publications, this article focuses on the potential impacts of higher U.S. tariffs on China.

Lingering impacts from the last trade war

The 2018-2019 U.S.-China trade war began with then-President Trump’s criticism of China’s unfair trade practices, resulting in the phasing in of tariffs on a total of approximately USD 550billion Chinese imports under Section 301 of the U.S. Trade Act. China retaliated at each phase, placing tariffs on approximately USD 185billion of U.S. imports. Tensions started to ease in mid-2019, and the Phase 1 Agreement was reached, where China committed to purchasing an additional USD 200billion of U.S. goods and services over the following two years.

The tariffs did not revive the U.S. manufacturing industry, as the manufacturing share of private employment continued to decline after 2018. They did not reduce the U.S. trade deficit. While the U.S.-China bilateral trade deficit narrowed, the trade deficit against other trading partners expanded drastically, resulting in the total U.S. deficit widening by USD 267billion.

However, the impact on trading patterns was significant. From 2017 to 2023, China’s share of U.S. imports fell by 7.7%, while Mexico, Taiwan, Vietnam and the euro area saw increases in import shares. It is worth noting that China’s share of global exports has actually increased by two percentage points over the period, highlighting how China has adapted by diversifying trade destinations towards emerging markets and using transshipments to bypass tariffs. However, some of China’s trading partners, like the European Union, Malaysia and Vietnam have increasingly expressed concerns over China’s cheap exports, launching investigations and placing tariffs on Chinese exports. The U.S. government has also been critical of China’s transshipments, putting in place tariffs and controls to limit this. Thus, while increasing exports to non-U.S. markets helped cushion some of the impact from the 2018 trade war, escalated tensions in the past few years may make it harder this time.

Source: FactSet, J.P. Morgan Asset Management. (Left) U.S Census Bureau; (RHS) IMF – Direction of Trade Database.
Latest data are as of 2023. Data reflect most recently available as of 09/12/24.

What could happen this time?

The eventual level of tariffs imposed remains highly uncertain, pointing to a very wide range of possible economic outcomes. The impact of the final tariffs will not only depend on the tariff level but also on whether they target specific product lists only, whether the administration will allow for exclusions (especially goods that cannot be easily substituted), whether tariffs are phased or not, and whether businesses will be allowed time to adjust. Moreover, tariffs might not only target goods finished in China like the last trade conflict but might also cover products produced elsewhere but with significant Chinese inputs.

Apart from the magnitude of tariffs, their scope and timing will also depend on which legislative authority President-elect Trump intends to leverage. The legal tools at his disposal include:

• Section 301: retaliation against unfair trade practices (used in the 2018-2019 US-China trade war, and President Biden’s 2024 tariffs)
• Section 201: protection of domestic industries (used in 2018 on solar cells and washing machines)
• Section 232: protection of national security (used in 2018 on steel and aluminum)
• Section 122: correct a balance of payment imbalance, allowing for maximum 15% tariffs, up to 150 days only
• International Emergency Economic Powers Act: response to emergency

Lessons from 2018: How might China react?

The priority would be to offset the tariff impact, which can be done in two ways:

• Depreciation of CNY: From peak to trough within the trade war period, the Chinese yuan (CNY) depreciated 15.6%, against a 12.7 percentage points increase in the effective tariff rate (according to Federal Reserve data). If the tariff rate is increased by 60% as threatened, the magnitude of depreciation required to provide a similar cushion will likely be too extreme. Moreover, USD/CNY was stronger in 2018 than it is today (6.3 compared to 7.3), limiting room for further depreciation.
• Fiscal stimulus: It is estimated that a 60% effective tariff rate would reduce China’s real gross domestic product (GDP) growth by 2% over the next 4-6 quarters, assuming no retaliation, as a result of lower exports, investments, consumption and spillovers from lower business confidence. The potential growth impact from tariffs, coupled with existing domestic challenges, will likely require more fiscal stimulus from the government next year.

Apart from cushioning the impact, China can also retaliate and/or negotiate.

Retaliate: China retaliated in the 2018-2019 U.S.-China trade war, and recent examples include retaliation against President Biden’s chip restrictions just a few weeks ago. Critical metals and minerals used for renewable energy, electric vehicles and semiconductors will likely be the next geopolitical battleground, given China’s integral role in these supply chains, coupled with high strategic demand globally. This grants China bargaining power as countries might find it difficult to diversify away from China.

Negotiate: China fulfilled less than 60% of the committed purchases under the Phase One Trade Deal, partly due to the onset of the pandemic. Nevertheless, this result could make reaching another deal more challenging.

Are we heading towards a decoupling? 

Developed markets are reducing their reliance on Chinese imports, but a complete decoupling will be difficult in the near term.

On one hand, taking the U.S. as an example, China still holds a 70-80% market share in the U.S.’s top 5 import categories in 2023 (e.g. lithium-ion batteries, smartphones, toys etc). Reducing that share will take time and cost, involving both sunk costs and large fixed costs to establish new trade relationships or relocate factories. On the other hand, China’s steady share of global trade is a testament to the fact that the economies of scale, infrastructure, manufacturing know-how and integration in global supply chains that took China decades to build is difficult to replace overnight.

All in all, the potential tariff hikes against China will accelerate existing supply chain reallocations. For China, this means a further evolution of its export markets mix, with demand from emerging markets gradually replacing that of developed markets.

Investment implications

Tariffs could hurt Chinese corporates’ revenue and profitability, especially exporters. However, it is worth noting that the MSCI China derives 87% of its revenue domestically, and only 4% from the U.S. Thus, tariffs’ direct impact on corporate earnings is less than any domestic fiscal stimulus, thus, the latter is still the important factor to watch. Apart from the scale and timing, the type of policies matter too. Policies that boost supply (e.g. manufacturing support) will likely exacerbate China’s current deflation problem, while policies that boost domestic demand (e.g. consumption stimulus) can prove more effective.

Investors should also be wary of tariffs’ indirect impacts. Firstly, given tariffs’ drag on growth, we could see domestically-generated revenues also shrink if there are significant spillovers and if overall economic growth slows. Secondly, the hit on investor sentiment could pressure valuations, as we saw MSCI China price-to-earnings ratios fall from 12.4 to 8.9 peak-to-trough in 2018.

Therefore, sector selection is key when investing in Chinese equities. Investors who wish to cushion the portfolio impact of tariffs should lean into defensive sectors. For example, in 2018-2019, utilities outperformed consistently in periods of risk escalations. Investors can also take refuge in services sectors or exporters focusing on emerging markets, which are less likely to be impacted by US-China trade tensions.

As we see further clarity in fiscal stimulus later in the year, the sector mix and domestic nature of the onshore A-shares market is better positioned to benefit from the policy tailwind (e.g. consumer discretionary). Compared to offshore Chinese markets, the onshore market is also less sensitive to the global investor sentiment impact from tariffs and CNY depreciation.

094n241012074708