Investors are driving blind as they wait to see whether further real progress is likely to be made in the weeks ahead on the high-stakes phase one US-China trade deal — high stakes because a former senior US official has warned that failure to reach an agreement could result in armed conflict between the two nations.

It’s six weeks down the line since the prospect of a first stab at a deal was touted after the much-hoped-for May deal fell apart. However, we are still no clearer on whether the phase one deal has any chance of being finalised in 2019 and, until there is a breakthrough, or disaster strikes, financial markets are priced for it to happen.

There was talk last week that the deal may not cross the finishing line before the end of 2019. Should this be the case, the most we could hope for is a postponement of the ground-breaking, in a bad way, tariffs scheduled to be imposed on Chinese consumer goods on December 15. With the consumer effectively holding up the US economy at the moment, Trump is playing with fire by allowing anything to potentially knock consumer sentiment at this delicate phase of the economic cycle.

Events in China over the weekend did give some hope that reason may prevail. Chinese President Xi Jinping’s largely constructive comments in Beijing’s Great Hall of the People suggested he may be the only adult in the room as he called for a phase one agreement to be achieved “on the basis of mutual respect and equality”. He balanced this with the warning:

“As we always said, we don’t want to start the trade war, but we are not afraid.”

In contrast, US President Donald Trump again claimed that Jinping “wants to make a deal much more than I want to make it”. But he did reportedly say the two countries were potentially close to making a deal.

It appears the main sticking points are China’s reticence to commit to buying a fixed value of agricultural goods from the US, in the region of $50-billion, while China wants to see the US roll back the September tariffs or at least take the December tariffs off the table. China has also reportedly said it won’t visit the US again in 2019, putting paid to Trump’s wish for a photo opportunity of the deal being signed in the American agricultural heartland.

Arguably the best news we have heard since the escalation in trade tensions in March 2018 was the Chinese announcement on Sunday that it was raising the penalties for intellectual property (IP) theft, as well as lowering the thresholds for criminal punishment of IP theft. This has been a major sticking point in trade negotiations, with the US committed to seeing China put an end to the theft of US IP. Other requirements are that China removes the obligation that companies share their trade secrets when operating in the country and for the government to stop subsidising state-owned entities.

Addressing these structural issues would open the door to a phase two deal, something that has been viewed as out of reach until now. Jinping says China will continue on the path of financial reform, “but will ensure the security of the nation’s financial sovereignty”. In other words, it will engage in the financial market and economic liberalisation in its own time and at its own discretion.

The upbeat investor sentiment that has predominated over the past few weeks belies what is potentially at stake if a deal cannot be finalised. Former US Secretary of State Henry Kissinger sounded the alarm on a worse-case scenario, should both countries not find common ground. He warned that the trade war could snowball into armed conflict.

Speaking at the Bloomberg New Economy conference in Beijing, Kissinger noted that the US and China were in the foothills of a new cold war, while former US Treasury Secretary Henry Paulson warned that decoupling between the two global powerhouses could mean that the world might not survive the next crisis.

Whether it escalates to the point of no return or not, the latest research by the Peterson Institute for International Economics confirms what is at stake for both countries if they do not achieve resolution of a phase one deal, at a minimum. In the report, US-China Trade War: Both Countries Lose, World Markets Adjust, Others Gain, authors Sherman Robinson and Karen Thierfelder warn:

“While there are potential gains from imposing tariffs and exploiting market power in world markets, the inevitable retaliation largely erodes or reverses the potential gains.” They point out that countries adjust trade patterns “to deal with the high levels of protection in the warring countries” and that these adjustments are costly and inefficient. They add that having diverted trade around the US, trading partners are not likely to return to US markets anytime soon.

“Markets that are lost because of even a temporary trade war may be irretrievable.”

Their research finds that both the US and China suffer, while all other countries gain. It points out that in the US, “increased tariffs operate exactly like a broad, large, sales tax on imported goods that is paid by US consumers — increasing prices and reducing demand — and by producers who see a rise in the cost of imported intermediate inputs, damaging competitiveness.”

Meanwhile, for the Chinese, consumer goods prices do rise as a result of the tariffs increase but, with China having exempted some intermediate inputs from the tariffs, producers are much less affected.

The research also shows that the hardest-hit sectors in the US would be exactly the sectors Trump can least afford to hurt, namely agriculture, manufacturing and traded services, while the output of non-traded services would increase relatively.

Given his America first and electoral commitments to make conditions better for the manufacturing and agricultural sectors, these are outcomes he cannot afford to incur. So when Trump says China wants to make a deal more than he does, most people would have a hard time believing him. BM