With the exception of intermittent Twitter tantrums, the last two weeks have been characterized by what counts as “trade optimism” these days.
To be sure, “optimism” is a relative term at this point. Escalation after escalation, tweet after tweet and tit after tat, have left markets war-weary to the point of exhaustion. But even as a kind of fatalism sets in, traders (both carbon-based and otherwise) can’t help but get sucked in on ostensibly positive headlines.
And so, “news” that the two sides are still in touch and plan to meet both at the working level (this month) and the principal level (some time early next month) helped bolster risk assets and push the VIX back to a 15-handle. It’s been a wild ride.
Everyone has their own framework through which to assess the odds of a Sino-US trade deal. Suffice to say optimism around the prospects for a pact ahead of the US election are “not good, not good”, to quote Trump.
For BofA’s Aditya Bhave, five lessons from a “war of attrition” game-theoretic model help inform a rather grim take on the likely evolution of the dispute.
First, Bhave writes that “the bigger the prize, the longer the fight”. Clearly, the prize is about as big as prizes come in this case.
“Over time it has become increasingly clear that the trade war is part of a much broader conflict between the US and China over technological and military dominance, and geopolitics”, BofA says. “Accordingly, both sides are likely to remain patient, pursuing this costly conflict for an extended period of time”.
Second, the bank doesn’t think fatigue is a factor – or at least not yet. “The length of the conflict to date has basically no bearing on how much longer it is expected to last”, Bhave cautions, adding that while “the costs of the conflict add up for both sides over time, the intuition is that past costs are sunk, so they do not affect decisions about the future path of the conflict”.
Third, BofA postulates that although Trump may have the upper hand, the fight is nowhere near as one-sided as trade disputes between, for instance, the US and South Korea, Mexico and Japan.
“The economic cost to China of fighting the trade war might be only modestly higher than the cost to the US [and] it is possible that China is able to bridge the cost gap by inflicting more pain on the US than other countries can”, Bhave says, on the way to noting that “when the two sides are similar in their willingness and capacity to fight, our framework suggests that the total cost of the conflict tends to be similar to the value of the prize that they are fighting for”.
That increases the odds of a “Pyrrhic” victory. More simply, the bank says that by the time this is over, the “damage done [may] exceed the winner’s gains”.
Fourth, BofA suggests that Trump might not be the only one playing the “crazy” card. The bank says that even if China is woefully outgunned, as a non-market economy, Beijing may be able to take the pain indefinitely. “Consider a scenario in which China has a higher cost of fighting the trade war than the US, but US policymakers are concerned that their Chinese counterparts might be ‘irrational’ [or that] they might have an infinite pain threshold”, Bhave says.
As the trade war drags on, Washington may become more worried about the possibility that China is economically irrational. Indeed, Trump has repeatedly suggested that China might try to wait him out until the 2020 election, despite the enormous economic costs. The US president has, at times, sounded incredulous that Xi continues to hold out in the face of what the administration insists are “millions” of lost jobs and factories “fleeing China”.
Of course, if China knows the US is concerned about this, they may keep fighting in an effort to demoralize Trump. As BofA puts it, “China might continue to fight for longer than it otherwise would have, even if it does care about the costs it is incurring”.
Finally, Bhave says the Trump administration’s decision to delay tariffs on consumer goods, the farmer bailouts and the incessant effort to convince voters that China is “paying for the tariffs” even when that assertion is manifestly untrue, may be perceived by Beijing as a sign of weakness. Here’s BofA:
From a strategic perspective, however, this move should make China more confident that the Trump Administration is responsive to economic incentives. In fact despite its somewhat out-of-the-box approach, we see plenty of evidence that the administration is sensitive to the costs of the conflict. It has issued subsidies to farmers to offset the pain from Chinese measures against the US agricultural sector, and President Trump often justifies the trade war by reiterating his view that China, not the US, is paying for the conflict. Our framework suggests that the knowledge that it is up against a “rational” opponent would make China more patient in terms of extending the conflict.
All of that (and the full note is obviously much longer, including an appendix outlining war of attrition games and elaborating on the framework), to come to a conclusion which is broadly similar to that adopted by other desks.
“Our game-theoretic analysis reinforces our view that the US-China trade war is unlikely to get resolved in the foreseeable future”, BofA laments, before admitting that “things probably have to get worse before they get better” and advising investors to “stay tuned”.