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3 stubborn myths about China and the trade war

Being able to distinguish between fact and fiction is vitally important when investors are navigating the choppy waters of the trade war, explains Danske Bank’s investment strategist Lars Skovgaard Andersen.

China and the US are set to kick off a new round of trade talks on Thursday in an attempt to settle the ongoing trade war that seems to be seldom off the front page at the moment. While it piques our ingrained fear of losing money, a number of myths are unfortunately distorting investors’ perception of the situation. Failure to adopt a critical stance on the flow of news and information could mean investors making decisions based on inaccuracies.

Let’s look at three of the most widespread myths:

MYTH 1: China has power over US government debt

A common myth involves China’s share of ownership of US government bonds. Investors may sometimes get the impression that China owns by far the largest share of US government bonds and could unceremoniously dump them if it wanted to hit the US. But while it is true that China has usurped Japan’s role as the largest foreign owner of US government bonds, China’s total share of ownership is just 7% compared to Japan’s 6%.

That 7% is of course ample to create chaos with if the Chinese suddenly decide to drop their investment, but the big question then is what would they get out of such an action? If the Chinese pushed the sell button, the value of their US debt holdings would dive and prove expensive for them, as naturally they cannot shed so many bonds in one go. At the same time, they would receive a huge amount of US dollars from the sale, and what should they do with them?

When ‘unnamed sources’ talk of this option, we view it as more part of the threat game – theatrical thunder to help balance out what comes the other way from the US.

MYTH 2: Rare earth metals give the Chinese a strong trump card

Another myth concerns the rare earth metals that the Chinese export to the US for use in, among other things, American IT products. It is correct that US companies are currently heavily dependent on the Chinese here, as they get around 80% of their rare earth metals from China – so yes, this would be a hefty blow to the US if the Chinese cut back on exports.

However, this would also be a short-lived setback for the US, as the rare earth metals are not necessarily that rare – they are just not that interesting to process if you can get someone else to do the work, as the refinement process involves a number of negative side-effects, such as radiation.

The US has mines that have been mothballed as operations were unprofitable, plus mines can be found in a number of other locations around the world, so the more the Chinese threaten to play this card, the greater the probability that other countries will ramp up production, or that tech companies will find viable alternatives. This happened when China threatened to cut exports of the rare earth metal neodymium to Japan as part of a dispute over the uninhabited Senkaka islands, which lie between the two countries. Toyota uses neodymium in its electric and hybrid cars, but the Chinese threats resulted in the Japanese car manufacturer developing a battery that uses considerably less neodymium.

Should the Chinese halt sales to the US, their pleasure could be short-lived, as in the longer term the Chinese would lose their dominant position in the market and dilute their clout. Hence, this card is worth a lot more in the hand than laid out on the table.

MYTH 3: A recession is poison for equity markets

The escalation of the trade war during the past year has triggered fears of an imminent recession, and the term has grown in the minds of many investors into a ferocious monster whose destructive forces could rain down on equity markets

This is likely due to the most recent global recession being in connection with the financial crisis, which was an extraordinarily hard blow for the financial markets. Here, the recession lasted 18 months in the US and cost a 34.8% loss for the US S&P 500 index – this is the recession imprinted on the minds of investors. However, recessions are in fact rarely as dangerous as they sound. They come and they go – since World War Two, there have been 11 recessions in the US, yet US equities have generated an average return of 4% during these recessions (and yes, that includes the very large price falls in connection with the financial crisis).

The myth of recessions as destructive monsters has been exaggerated. While the trade war could trigger a recession if it deteriorates or carries on for a long time, that is not necessarily the end of the world for equity markets. We should remember that despite the trade war and the considerable talk of a recession, global equities have in fact risen by 15.8% so far this year (in local currency). Moreover, we at Danske Bank do not expect an imminent recession – trade war or not.

Further negotiations in the us

The Americans and the Chinese are scheduled to meet on Thursday and Friday of this week (10-11 October) in Washington for further negotiations on a trade deal. Meetings will include one between China’s vice premier, Liu He, US trade representative Robert Lighthizer and US Secretary of the Treasury Steven Mnuchin

Danske Bank has prepared this material for information purposes only, and it does not constitute investment advice. Always speak to an advisor if you are considering making an investment based on this material to establish whether a particular investment suits your investment profile, including your risk appetite, investment horizon and ability to absorb a loss.

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