Tariff Threat Puts Damper on Chinese Stocks

 Ellen Chang

The proposed $60 billion tariff on Chinese imports has battered Chinese stocks for the past few days, but the long-term effect remains unclear – although losses could spread to other markets.

On the brink of a trade war, the U.S. dollar-based Chinese shares that track the MSCI China index declined nearly 7 percent last week, and investors remain wary that the tariffs imposed by President Donald Trump would hamper stock returns. Stocks rebounded on Monday after Treasury Secretary Steven Mnuchin said he was "cautiously optimistic" that tariffs on Chinese goods can be avoided, but most investors remain apprehensive.

Many who want exposure to China own SPDR S&P China ETF (ticker: GXC) and offers a broader exposure to Chinese companies, the iShares China Large-Cap ETF (FXI) or the iShares MSCI China ETF (MCHI). The SPDR ETF is heavily concentrated in information technology with 34.9 percent and 22.4 percent in financial stocks.

The long-term effect on these stocks is difficult to determine at this stage, says David Lei, an associate professor of strategy at the Cox School of Business at Southern Methodist University in Dallas. "What drives stock movements in reality is always hard to gauge," he says.

One problematic issue is that if stock prices take a plunge in China, the risk could grow and the contagion could spread to other emerging markets and perhaps to the developed economies.

"The announcement heralds not only the embers of a looming trade war, but also the beginning of the reckoning as to how markets re-price growing uncertainty and higher costs on the earnings potential of firms worldwide," Lei says.

The tariff on technology imports is only the beginning of a wide-scale trade war that will not end at least for another two to three years, says K.C. Ma, director of the Roland George investments program at Stetson University in DeLand, Florida.

"Following January's tariff on solar panels and washing machine and March's tariff on steel and aluminum, brace yourself," he says.

The government's proposal to impose tariffs is "unlikely to have a significant impact on the Chinese or global economy" because $60 billion is equivalent to around 2.5 percent of China's total merchandise exports, or 0.5 percent of its GDP, says Andrew Fennell, director of sovereigns at Fitch Ratings in a research note.

"But the impact of the tariffs on the Chinese economy would be much smaller," he says. "Some of these goods will still end up going to the U.S., given the lack of substitutes, while others could be diverted to different markets."

Chinese stocks, especially those in the steel, machinery, electronics and telecommunications sectors, could be impacted since the prospect of tariffs will likely exacerbate a pre-existing slowdown in the Chinese economy, Lei says.

"Recent market reports about declining future business orders in the Chinese suppliers' index suggest the internal demand has already begun to flatten out," he says. "Although Chinese manufacturers typically could rely on rising exports to compensate for reduced domestic demand in the past, the tariff headwinds will probably magnify the potential future earnings weakness in major Chinese stocks."

The Chinese companies that have a significant amount of debt are the most vulnerable to decreased export demand or rising costs since they are probably operating with excessive slack capacity already.

"Many Chinese steel companies are heavily concentrated in China's own rust-belt in the north and the northeast," Lei says. "It is those state-owned or state-subsidized enterprises that will likely bear the brunt of tariffs in China."

These tariffs will have a bigger impact on consumption because if imports decline due to increases in price, Chinese manufacturing stocks would see some pretty steep declines, says Patrick Morris, CEO of New York-based Hagin Investment Management.

"Since China is threatening to retaliate, I can only assume Trump will retaliate with even higher tariffs," he says. "This risks putting the global economy on the course toward recession. We haven't had one of those in a very long time, so the market declines could be quite shocking."

The amount of money that has been loaned to companies in both the U.S. and China over the past decade is noteworthy.

"Most companies have some debt on the books and any major slowdown could have broad, very negative implications in both countries," he said.

The impact on stocks will be minimal since China's GDP is $11.2 trillion, which includes $115.6 billion in Chinese exports while imports tally $462.6 billion, says Bill DeShurko, president of 401 Advisor, a registered investment advisory in Centerville, Ohio.

"China's stated economic goal is to balance this difference, primarily by boosting domestic purchases of their own goods," he says. "They want to reduce their reliance on exports. I'm not so sure China is very worked up about this."

While China announced its own tariffs targeting $3 billion worth of U.S. agricultural goods in response to the U.S. tariffs on steel and aluminum, Premier Li Keqiang says that "a trade war does no good to either side."

The impact of a tariff on Chinese high-tech imports on a forced transfer of intellectual properties will impact more than just the Chinese stocks, Ma says.

"A tariff will raise the cost of the largest U.S. importers, such as Walmart (WMT), Target (TGT) and Lowe's (LOW), and will eventually turn into 'imported inflation' to the American economy," he says. "There is no winner in a trade war."

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