China, US trade war: This is how it could play out

The threats of a trade war have hit markets and investor risk sentiment in recent weeks. While the tariffs could put some near-term pressure on companies, over the longer term the U.S. has the upper hand in this battle. But, according to Melius Research, if things don’t go well, the saber-rattling could double the risk of a recession.

“No one seems to want to risk free trade, but behind the scenes many of our CEOs are supportive of some action to level the playing field,” according to notes from Melius.

Melius believes it is likely that the U.S. and China will come to some sort of trade compromise but noted that the risks of a recession are higher now, due to the latest policy developments.

In the near term, tariffs add risk and lowers price-to-earnings (P/E) ratios, while in the longer term the tariffs will either drag the world into a recession or will be resolved to get the cycle back on its upward trajectory.

The best case scenario

In terms of the bull case scenario, Melius Research believes that the Chinese will realize that intellectual property (IP) theft is not sustainable. Also, the country has made progress in building out their own R&D capabilities, which puts them in the position to compromise on IP theft, with little cost.

While China has threated to retaliate with tariffs on agricultural goods such as soybeans, according to Melius, the Chinese have more to lose than the U.S. when it comes to targeting the food supply.

“Putting tariffs on U.S. food exports would actually hurt the Chinese more than the U.S. because the U.S. has the largest supply of low-cost agriculture and infrastructure to export in the world,” Melius said in a report. Additionally, China’s need to import protein will not decrease.

The research firm thinks a settlement to the trade war is easy and should be acceptable to both parties.

The worst case scenario

In the worst case scenario, the tariffs could be an event that would trigger a down cycle, and that down cycle would likely result in companies buying back stock rather than investing repatriated cash.

Melius says Washington, D.C. needs to carefully consider the potential negative fallout beyond just trade deficits and unfair trading, noting that, “The Fed has barely begun raising rates, and debt levels are high, the country cannot afford a recession now.”

“We see the odds of policy mistakes driving us to recession as 20% currently vs. something closer to 10% before this mess,” the company said.

Bullish? Here’s where you should invest

For those who are bullish despite the tariffs, Melius recommends Rockwell Automation (ROK), Emerson Electric (EMR), Honeywell (HON),  Eaton Corporation (ETN) and Rexnord (RXN).

Ticker Security Last Change Change %
ROK ROCKWELL AUTOMATION 284.15 +2.48 +0.88%
EMR EMERSON ELECTRIC CO. 97.03 -0.56 -0.57%
ETN EATON CORP. 146.63 -0.19 -0.13%
RXN REXNORD CORP 51.27 +0.60 +1.18%