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Today’s Points:

• The US says it will put a 100% tariff on Chinese imports from Nov. 1.
• China doesn’t look like compromising; Trump might be offering an olive branch. 
• US stocks responded with their most drastic selloff in six months.
• In France, Macron has appointed yet another new cabinet.
• In Japan, prospective PM Takaichi is fighting to piece together a new coalition.
• AND: Farewell to the wonderful Diane Keaton.

Trump, the Trade War and Markets: Episode V

At last we can explain why markets have been behaving as though all uncertainty over trade policy and tariffs had been resolved, even though it clearly hadn’t. Mr. Market really believed it was all over. That’s clear from the extraordinary reaction to the latest trade expostulation from President Donald Trump, who will slap 100% tariffs on all Chinese imports next month in response to new restrictions on the flow of rare earths from China.

This is a big deal, which we analyze below, but the market withstood Trumpian threats of 145% tariffs on China six month ago. While there’d been a negotiating pause in trade hostilities, neither power has ever pretended to reach an ongoing, durable solution. This is bad news, but shouldn’t qualify as a major surprise.

And yet US markets took a dive Friday. They’re still up for the year, and this may just be a correction, but it was drastic:

Crypto had one of its worst days in history. Only once, in the wake of the Liberation Day tariffs in April, had so much Bitcoin wealth been wiped out in one day:

MSCI’s index of the 100 developed-market companies most exposed to China had been rallying. It sharply reversed: 

The China trade conflagration may just be an excuse to take profits (and stock futures and oil enjoyed a bounce in Monday’s early Asian trading). It’s also possible that the relationship between markets and Trump 2.0 is in a new phase. So far, the response to the extraordinary upheaval in economic policy has moved in four stages:

• Election Euphoria

As Kamala Harris’ chances ebbed after her strong performance in the one presidential debate, markets went on a tear. Trump 1.0 was taken as a guide; he viewed stocks as a validator, so there would be a “Trump Put.” The policies investors liked — tax cuts and deregulation — would happen, while those they didn’t — tariffs and an immigration clampdown — would be watered down. The way Trump brought Silicon Valley’s lords onside boosted belief in a great pro-growth administration.

• Sell America

After the inauguration, a rethink set in. Trump pressed on with tariffs, and said: “Markets are going to go up and they’re going to go down but, you know what, we have to rebuild our country.” The administration talked about “detox” for the economy. Trump posted about firing Jerome Powell from the Federal Reserve. Then Liberation Day on April 2, unveiling tariffs far higher than anything the administration had trailed, and a swift escalation to 145% tariffs on China, really set the cat among the pigeons. The narrative now was that money would exit America.

• TACO (Trump Always Chickens Out)

Once the administration said that tariffs on all nations but China would be paused for 90 days, the market enjoyed one of the biggest swings in history. A subsequent ceasefire with China, and acknowledgement from Trump that he wouldn’t fire Powell, combined with a return to boosterish White House pronouncements about the stock market to ram home the notion that Trump always chickened out. By the end of July, taking the relative performance of stocks and bonds as a gauge, all the lost ground from Liberation Day had been made up.

• ?????

Market performance since the end of July has been more of a question mark. The Liberation Day tariffs ended up being applied with close to the full force that was originally announced. “Deals” with the UK, the EU, Japan and others were vague and resolved nothing; countries as significant as Brazil and India faced even higher levies than first announced. Trump tried to fire the Fed Governor Lisa Cook as central bank independence remained very much up for grabs. But the rally continued until Friday’s correction. This could be the moment when the Trump trade takes a new direction — or it could prove to be a correction to speculation. A healthy start for stock futures on Monday Asian trading leaves both interpretations open.

This is how the Trump trades have played out, mapped by the relative performance of the S&P 500 and 20-year+ Treasuries (the SPY and TLT exchange-traded funds):

Were markets really working on the assumption that the trade issue was resolved? Is Mr. Market that naive? 

There certainly seems to be some naivete going on. That said, the administration has done much to get its ducks in a row in a way that they weren’t six months ago. Treasury Secretary Scott Bessent has aimed for lower bond yields, a cheaper dollar, cheap oil and strong stocks. Between them, they keep the economy juicing nicely, aid competitiveness and minimize the experience of inflation. And he’s getting all of them (even after the selloff). Indeed, Friday’s big drop in the oil price even helped:

Meanwhile, the provision of abundant liquidity (even if the Fed keeps overnight rates too high for the administration’s taste) has put market volatility to sleep, in stocks, bonds, and currency. This helps, a lot:

And one dog didn’t bark on Friday. Trump admitted that the April tariff climbdown was driven by “yippy” bond markets. The way bonds sold off after Liberation Day was a classic sign of lost confidence in the US as a jurisdiction, as often suffered by emerging markets. This time, investors seem to have treated bonds as a haven once more; they had a strong gain on Friday: 

Markets’ confidence wasn’t as great as it appeared. But its foundations remain intact for now. Whether this situation escalates will depend on the two sides’ motivations. 

Two Can Play That Game

China’s export curbs on rare-earth minerals are as striking as the forces driving Beijing such extremes. On Thursday, Beijing unveiled a new directive that if Western countries continue to restrict sales of advanced chips, high-bandwidth memory, and chipmaking equipment to China, it would halt exports of the rare earths that those technologies depend on. Subsequent briefings muddied the waters over exactly how to interpret the move. The Ministry of Finance said (as translated by Google Translate):

China’s export controls do not constitute export bans. As long as the export application is for civilian purposes and complies with regulations, it will be approved. Relevant companies need not worry.

But a spokesman also accused the US of “double standards” and abusing export controls in the name of national security:

Frequently threatening high tariffs is not the right approach to engaging with China. China’s position on a tariff war is consistent: We do not want one, but we are not afraid of one... If the US insists on its own way, China will resolutely take corresponding measures to safeguard its legitimate rights and interests.

It’s worth reading the entire text. Few had penciled in such heightened tension, as investors’ immediate reaction proved. For Trump, his 145% tariff threat earlier this year means his additional 100% tariffs atop existing levies shouldn’t be surprising. As the response only takes effect after he meets Xi in South Korea later this month, it could just be a negotiating tactic — but he’s suggesting he might not show up. 

What exactly is China trying to do? The most likely explanation is that, by mirroring US semiconductor restrictions with its own rare-earth minerals restrictions, Beijing is trying to focus the negotiations on export controls and investment flows, argues Louis-Vincent Gave of Gavekal Research:

In addition to lower tariffs, China would like to get the US to relax its export controls on advanced semiconductors and open pathways for Chinese companies to invest in the US. Its main source of leverage is the rare-earths export controls (although its de facto ban on soybean imports from the US also seems to have gotten under Trump’s skin).

The motive behind China’s move matters just as much. How much tariff pain can Beijing endure? Dan Wang of Stanford University’s Hoover Institution argues that it may be a strategy of overplaying its hand to see what it can get. But Andrew Bishop of Signum Global Advisors points out that China could escalate further. Other points of leverage over the US include “pharmaceutical ingredients, military inputs, specialty chemicals, and semiconductor packaging and foundational production.”

Beijing’s impudence stems from its capacity to hit Washington where it hurts most. To quote Gave, “China’s ability to disrupt US supply chains, especially in politically sensitive industries such as weapons manufacturing and autos, is now very high.” Conversely, US efforts to derail China’s artificial intelligence efforts appear to be faltering and may prove counterproductive, as they have forced Chinese engineers to find ways to operate with less energy and computing capacity. Necessity is the mother of invention, as argued by Nvidia CEO Jensen Huang.

As China’s policymakers gather later this month to set the next five-year plan, few priorities loom larger than staking a credible claim in the global AI race. Expanded electricity generation gives it a head start, as Points of Return recently noted. Wang points out that China now produces roughly twice as much electricity as the US:

China this year will deploy about 500 gigawatts of solar alone. The US will deploy 50. So, just an order of magnitude difference. There are 33 nuclear power plants under construction in China right now. There’s zero under construction in the US. 

Beyond electricity, research and development spending has surged by 48% over the past four years, above the 40% target in the current Five-Year Plan. Larry Hu of Macquarie notes that R&D has now topped the European Union’s as a share of gross domestic product:

China has long experience in mercantilism, but it has to find a way to coexist with the US. That requires demonstrating enough leverage to keep Washington at bay. Whether it gets the balance right might just be the most important question of our time. 

— Richard Abbey

Survival Tips

Rest in peace, Diane Keaton. She will always be remembered as Annie Hall. But her range was extraordinary. She was great in Woody Allen’s comeback movie Manhattan Murder Mystery. And she delivered the pivotal moment in The Godfather Part II as Kay Adams, who fell in love with the brilliant and idealistic young Michael Corleone, but is frozen out in finding herself married to the ruthless and cold-hearted Godfather. Thank you, Diane, and have a great week everyone. 

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