US-China Trade War Strains Credit Outlooks as Moody’s Downgrades US, Eyes China

US-China Trade War: China Keeps Its Sovereign Rate

Moody’s downgraded the US sovereign credit rating from Aaa to Aa1 on May 16, citing concerns about the inability to address large and growing deficits. The move followed earlier downgrades by Standard & Poor’s (2011) and Fitch (2023). The downgrade came at a time of heightened market tension due to the ongoing US-China trade war.

Despite 30% US tariffs on Chinese goods, Moody’s maintained China’s sovereign credit rating at A1, negative outlook on May 26. China’s finance minister reportedly welcomed the decision, stating the rating decision reflects confidence in the economy.

Moody’s Balances Risks and Resilience

Moody’s cited signs of improved economic resilience and quality growth in China. The agency noted that while the debt burden may grow, low interest rates and strong domestic savings could partly mitigate its impact.

Moody’s also referred to China’s controlled financial environment and demand for government debt as stabilizing forces. However, Moody’s maintained its negative outlook due to ongoing trade tensions. The rating agency warned:

“The uncertain trade policy environment poses downside risks to the level and quality of growth in China. Progress in fostering higher-productivity sectors is positive, but growth remains sensitive to exports given weaknesses in domestic consumption.”

Moody’s added that a significant, lengthy trade shock, involving trade restrictions, may result in a downgrade.

Beijing Braces for a Long Trade Battle

On May 25, Chinese state media downplayed the chances of a swift end to the US-China trade war. CN Wire reported:

“A commentary cited by Chinese state media underscores that the U.S.-China trade conflict remains unresolved, emphasizing that upcoming economic and trade negotiations will be protracted and arduous.”

The state media also warned the US may adopt delaying tactics to mitigate its economic losses and highlighted escalation risk, stating:

“If domestic political and economic pressures ease in the U.S., tariff threats could resurge.”

State media concluded:

“Given the enduring and complex nature of the confrontation, China must not only prepare thoroughly for negotiations but also brace for a prolonged struggle.”

Given Moody’s ratings rationale, a China downgrade is feasible if the US escalates the trade war and China endures a lengthy battle to lower restrictions.

Truce Tested, Markets React

The US and China agreed to a 90-day trade war truce on May 12, lowering tariffs from 145% to 30% on Chinese goods and from 120% to 10% on US goods. However, the absence of follow-up talks and the rising threat of a return to pre-truce tariffs pose downside risks to markets in Mainland China and Hong Kong. Conversely, progress toward a trade deal would boost risk sentiment, fueling demand for risk assets.

However, US markets are also exposed to tariff risks. Economists argue the US economy is more vulnerable to a prolonged trade war because of its reliance on Chinese imports. In contrast, market experts see China’s government as better placed to shield it from economic fallout.

Hong Kong Stocks Outperform

As trade war tensions linger, US and Mainland China markets have converged in recent weeks. Mainland China’s CSI 300 is down 2.45% year-to-date, while the Nasdaq Composite Index has declined 2.97%.

An end to the trade war truce and higher tariffs may lead to heavier losses for the Nasdaq, which narrowed the gap in May, rallying 7.4% vs. a 1.8% gain for the CSI 300.

Meanwhile, the Hang Seng Index remains a standout, with a year-to-date gain of 15.76%.

Outlook

Trade headlines continue to dictate market sentiment. Renewed US-China trade tensions may trigger a flight to safety, while fresh stimulus measures from Beijing could support markets. Fed commentary will also be key, especially regarding inflation risks tied to tariffs.

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