Heres why stock-market investors are so worried about the U.S.-China trade skirmish

It seems like the U.S. is scrapping with most of its major trade partners, but its the battle with China that grips investors most.

And why not? After all, as the worlds second-largest economy, China plays a key role in fostering global growth. Also, most investors dont need a reminder of Beijings ability to send ripples through global financial markets via its currency. Less than three years ago, a devaluation of Chinas yuan currency, also known as the renminbi, triggered a sharp selloff in global equity markets that also engulfed Wall Street.

I do have concerns that they could do a quick unannounced adjustment and I think that could be very disruptive here, because it was last time, said Randy Frederick, vice president of trading and derivatives at the Schwab Center for Financial Research, who is upbeat overall on the longer term outlook for stocks.

That might explain the relief rally that took hold Wednesday morning when the Trump administration announced it would rely on existing laws to restrict Chinese investment in the U.S. rather than new measures that would have allowed the White House to impose stricter limits on its own. Early gains didnt endure, however, with the S&P 500
SPX, -0.86%
off 0.3% in afternoon action and the Dow Jones Industrial Average
DJIA, -0.68%
shedding around 55 points, or 0.2%.

Theres no sign trade issues are on the back burner. A 25% tariff on $34 billion of Chinese imports are due to take effect on July 6, which are likely to draw promised retaliation from Beijing. In addition, President Donald Trump has asked U.S. Trade Representative Robert Lighthizer to identify an additional $200 billion in imports that could be subjected to a a 10% tariff and has threatened further levies beyond that if Beijing retaliates.

See MarketWatchs trade-war tracker

With 2017 exports to the U.S. of $130 billion, China couldnt fully match the scope of the U.S. tariffs a point often made by administration officials. But analysts note that China has other potential weapons, with the most effective being the renminbi.

This fall in the renminbi clearly fits the narrative that Chinese policy makers are allowing a weaker currency in order to deaden the impact of U.S. tariffs and perhaps suggest to the U.S. that there are other ways to retaliate than tit-for-tat tariffs, said Steven Barrow, currency and fixed income strategist at Standard Bank, in a Wednesday note.

On Wednesday, Chinas central bank appeared to intervene to halt the yuans decline, The Wall Street Journal reported, after earlier setting the currency at a six-month low against the dollar. The yuan dropped as much as 0.9% against the dollar in mainland China trade
USDCNY, +0.0121%
during early Asian trading hours, dropping to its lowest level versus the dollar since Dec. 19.

Chinas economy was already expected to slow even without a trade war. Oxford Economics has forecast growth to slow from a 6.8% year-over-year pace in the first quarter to 6.2% by the fourth quarter.

See: Escalating U.S.-China trade spat comes at a bad time for global growth, economist says

Chinas economy has already been clouded by a sharp slowdown in fixed asset investment growth due to the governments deleveraging drive, a problematic property sector, a mounting debt burden and rising credit defaults. The rising risk of a disruptive trade conflict can only make a bad situation worse, wrote analysts at Nomura, in a Wednesday note.

Meanwhile, the yuans weakness is raising suspicions, said Brad Bechtel, global head of FX at Jefferies LLC, in a Wednesday note. For investors, he said, the question is really about what it means for global markets:

It does make Chinese goods cheaper and basically exports deflation around the world when the CNH [offshore yuan] weakens but the effects are lagged by 6 months or more. It is also sparking a reaction in Asian EM FX which has been riding along with it, and should help their exports as well which have already been relatively stable. The rise of the broader USD is probably more problematic for markets as we have been seeing in recent months and at some point that hits US exports and puts downward pressure on US inflation as prices on imports drop.

Indeed, the yuan is also viewed more broadly as an indicator of emerging-market stress, said Ian Lyngen, head of U.S. rates strategy for BMO Capital Markets, in a Monday note.

At the same time, Chinese officials would likely be reluctant to weaken the yuan sharply out of fear benefits to exporters would be swamped by the potential for economic and financial instability, wrote analysts at Capital Economics.

Meanwhile, the global economy has shown signs of stabilizing, noted Chiara Silvestre, economist at UniCredit Bank in Milan. And while the trade measures announced so far by the U.S. and its rivals are unlikely to have a strong negative impact on growth, the danger of escalation remains a big worry, she said, in a note.

The balance of risks for the global economy is therefore now shifting significantly to the downside, Silvestre said.

The question for U.S. investors is how well insulated the domestic economy and markets are from trade-related turmoil. A pickup in U.S. growth in the second quarter as global data point to slowdowns elsewhere have provided some solace for bulls, as evidenced by the outperformance of small-cap stocks, which are more focused on the domestic economy, analysts said.

William Watts

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