Today Reuters is reporting that the US received a cable from Beijing late last week with major edits to a 150-page draft trade agreement that has been under negotiations for months. Yesterday the US stock market dropped 1.7%, attributed by many to be as a result of the breakdown. The draft agreement includes seven chapters with a broad range of topics from theft of US intellectual property and trade secrets; forced technology transfers; competition policy; access to financial services; and currency manipulation. Multiple government and private sources confirm the edits to the draft agreement was ‘riddled with reversals by China’.
To be honest, when positive news came out earlier this year that negotiations were going well , I was very skeptical. Today, I want to talk about negotiating strategy and why I believe a trade deal prior to the next presidential election is highly unlikely. If it does occur, it may not be as favorable to the US as the last draft agreement prior to the edits.
The First Rule of Negotiation
I spent 10+ years managing a team responsible for negotiating technology licensing agreements with both US and foreign companies. In the late 90’s I attended an executive training course at Northwestern University. The negotiation course was taught by Max Bazerman who is now on the faculty at Harvard. I’ll credit Max for what I call, The First Rule of Negotiation – consider the other sides alternatives to a negotiated agreement. It sounds obvious but, when people put together negotiating plans, they often fail to consider the other sides options. Always start there.
What is China’s Negotiation Strategy
Though I don’t have any inside information on China’s strategy, I would say look at history to build a premise for what might be going on. China has a very long history. They tend to be very patient in negotiation. They tend to focus on the long-term benefits to China vs. short term gains. Foreign car manufacturing in China is a case in point. Without joint ownership, foreign auto makers cannot build in China. Furthermore, the manufacturer is limited to two joint ventures. In the short run, Chinese consumers are limited in their ability to get a foreign vehicle. Chinese manufactures learn a great deal about how to make high quality cars from foreign companies in these joint ventures. There is a net flow of intellectual property (patents, copyrights and trade secrets) into China. It helps with the long-term competitiveness of an entire industry.
Back to the trade deal. Let’s assume reports are accurate, that China substantially reversed prior negotiated positions. What sort of strategy might China be executing? Why would they reverse their position? I would presume the changes are well thought out and not an accident.
What are the US Positions?
President Trump made trade deals a key part of his administration’s policy. His administration has taken a very tough stance with tariffs and negotiating positions. What could be behind China’s strategy? We can see that the US politicians are not in full agreement in how to handle China. It is safe to say that China may secure a more favorable deal if they delay negotiations. China could stall and if a weaker trade president candidate beats Trump, the deal could look much better for China. There is also an outside chance congress moves to impeach President Trump. This could also weaken the US power in the negotiation.
What are Trump’s Alternatives?
Option 1: Accept a Weaker Deal. The Chinese position has President Trump trapped. How? Well, to make good on his promise, Trump might feel pressure to get a deal done prior to the next presidential election. He may concede in part to the major changes now being proposed.
Option 2: Continue to Bargain Hard. The problem with the alternative is that as the presidential election draws closer, pressure grows to get a deal done. A deal that is perceived to be fair will help propel the stock market. In Trump’s mind he may see a deal as a huge win for re-election.
Analyzing China’s Strategy
Again, this is speculative, but if I am on the Chinese team, the way I would see it is that Trump is trapped. Either he will be forced to sign a bad deal OR stalling will create a big problem for the US. If the deal doesn’t happen it is very likely the stock market will see this as a big failure and stocks could drop as we approach the election. That would not be positive for any re-election odds for Trump.
What is the worst case for China if they stall and dig in? Well, if they don’t do a deal now they may face an easier negotiation if Trump loses re-election. A new democratic president would arguable be much less willing to take such a hard line. Trump can continue to increase pressure by adding more tariffs. The problem is that while tariffs hurt China, they are likely to be able to bear the pain for quite some time. China is more likely to stay unified on a hard line stance than the politically divided US.
Summing it All Up
Unfortunately, the way I see it the Chinese have Trump trapped a bit. We don’t have agreement between both sides of the political aisle on how to handle trade, and that is a very bad thing for any US negotiating power.
Given the analysis, I think China can afford to wait for the next election and see if they might end up with an easier negotiating partner. I just don’t see the tariffs causing enough pain on China to get them to change course in 24 months. For these reasons, I think the odds of a deal before the election are low. Maybe 30%. If a deal happens, I think the terms won’t be anywhere close to the prior draft agreement.
Was this all calculated strategy? It is possible. Build up hope, get the US people and stock market excited about the prospects of a deal, then with a series of moves take all wind out of the sales methodically as the election draws nigh. A cynical view, it may be, but I think that is much more likely then presuming the latest reversals were just a chance in mind.
What does it all mean for US stocks? It’s hard enough to get the scenario right. On top of that, the market impact will be a function of market expectations and then we have timing to deal with. Given all of the variables, I’d continue to focus on valuation and US growth.