It's time for markets to end their illusions about a US-China trade deal

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Financial markets should abandon any remaining illusion that U.S.-China trade talks are a time-constrained, tradable event that ultimately will result in a deal reassuring investors. Near dead is the notion that both sides would inevitably compromise because they so badly need agreement for their own political and economic purposes.

What markets have misunderstood since the negotiations resumed last December – but U.S. and Chinese officials have grasped – is that the talks had become just one of many events of a new era of geopolitical and systemic competition that will define our times. To earn their pay, market analysts will have to get a lot better at pricing in geopolitical risk.

Trump's decision to more than double tariffs on $200 billion in Chinese goods, from 10% to 25%, received the most global attention this week. His move, which was fueled by the argument that China was backing out of already-negotiated terms of a draft agreement, has the potential to be the most significant of the many trade moves of his administration.

Escalated tensions of other sorts went less noticed. On Monday, two U.S. warships sailed within 12 nautical miles of disputed islands in the South China Sea, the third time this year Washington has challenged China's maritime claims. At a 5G security conference in Prague a few days earlier, the U.S. and its allies drilled down on the dangers posed by the Chinese telecom giant Huawei – even as its CFO remains in Canadian custody.

Make no mistake. Even if the U.S. and China seek out a trade agreement in coming weeks, it would do very little to change the relationship, which has been fundamentally altered over the past months, from one of strategic engagement to one of sharper competition. Expect economic, political and even military risks to rise until skilled strategists and diplomats from both sides establish principles and rules of the road to govern the world's most decisive bilateral relationship.

More than just trade

It's worth rewinding this Sino-U.S. movie by about a week to understand how trade talks have been increasingly less about trade. The details behind the scenes underscore how history, nationalism, systemic differences, and increasing mistrust and miscalculation, have become a combustible mix.

Last weekend, it's a safe bet that Trump didn't know about the historic Chinese anniversary that made his tweeted trade bombshell even more inflammatory. His decision to turn the tariff screws tighter coincided with the 100th anniversary of Chinese student protests that then became the legendary May Fourth Movement. The upheaval was a nationalist and anti-imperialist response to what the students at the time considered their government's criminally weak handling of terms posed upon them in the post-World War I Treaty of Versailles.

It's been reliably reported that Chinese President Xi Jinping personally intervened last weekend to pull back his negotiators. Beijing appears to have changed several provisions in the draft deal, but what seems to have been most unacceptable to Xi was U.S. insistence that he agree to specific language about how China would change it national laws to abide by the deal's terms.

In each of the seven chapters of the draft, Reuters reported, China had deleted commitments to change laws to resolve U.S. complaints: theft of U.S. intellectual property and trade secrets, forced technology transfers, competition policy, access to financial services and currency manipulation.

May Fourth Movement activists, of whom many became Communist Party leaders, would have been rolling in their graves if negotiators had given that kind of ground to American rivals on their centennial. For a leader like Xi – who has staked his legitimacy on ending what his supporters see as China's "century of humiliation" at the hand of foreign powers – the on-again and off-again trade talks had become about so much more than trade.

Mixed signals

Trump had been wagering he had greater leverage because of the strong U.S. economy, with growth at 3.2% and unemployment at historic lows. At the same time, he reckoned the Chinese economy was fragile, based on its 2018 performance, and that its leaders ultimately would make the required concessions.

By contrast, XI represented a conviction among many in China that Trump would need a "win" that would reduce the deficit and create U.S. jobs before 2020 elections, and thus his negotiators would blink first. Xi also had grown more confident after a first quarter economic rebound as his government's stimulus measures took hold and helped produce 6.4% growth.

Tweets from Hu Xijin, editor-in-chief of the Chinese state-run Global Times, showed how China's position hardened throughout the week. While Hu's posts aren't as authoritative as Trump's tweets, he has become a fairly accurate indicator of what Chinese leaders are thinking.

At 8:47 a.m. Thursday, he tweeted that someone from the Chinese side "who knows the trade talks well" said that there was zero chance of a deal by Friday.

At 11:09 a.m. he tweeted: "China has fully prepared for an escalated trade war. It is a new strategy of China to engage in trade talks while fighting a trade war. I think China bets on the fact its politics is more powerful than US politics. Trade war will be decided by domestic politics eventually."

Then a little more than two hours after that, at 1:17 p.m., he put it all into perspective: "More and more Chinese now tend to believe the current US government is obsessed with comprehensively containing China. A trade deal, even if reached, will be limited in actual meaning and could be broken constantly. So they support being tough on the US, giving up an illusion."

A lot of illusions are dying this week.

After talks ended on Friday without progress, Hu brought down the curtain on the week: "Based on what I know, Chinese side insists on a few core points: US side should remove all additional tariffs, amount of purchase the US requests should be in line with reality; the text of the agreement must respect sovereignty and dignity."

Frederick Kempe is a best-selling author, prize-winning journalist and president & CEO of the Atlantic Council, one of the United States' most influential think tanks on global affairs. He worked at The Wall Street Journal for more than 25 years as a foreign correspondent, assistant managing editor and as the longest-serving editor of the paper's European edition. His latest book – "Berlin 1961: Kennedy, Khrushchev, and the Most Dangerous Place on Earth" – was a New York Times best-seller and has been published in more than a dozen languages. Follow him on Twitter @FredKempe and subscribe here to Inflection Points, his look each Saturday at the past week's top stories and trends.

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