Here’s how Trump can hit China’s economy where it really hurts as analysts say Beijing’s rare earths gamble could backfire

US-China trade tensions have reignited following China's rare-earths export controls, prompting President Trump to impose new tariffs and software restrictions while asserting the US holds stronger "monopoly positions" for potential retaliation. Capital Economics views China's action as a negotiating gambit, but highlights significant US leverage, including potential bans on critical aviation components, restrictions on software like Windows, expanded chip export controls, and financial sanctions via dollar assets and SWIFT. This escalating friction risks a deeper US-China decoupling, potentially isolating China from Western markets and technology to a greater degree.

Analysis

China's recent imposition of rare-earths export controls has reignited significant US-China trade tensions, prompting an initial response from President Trump of 100% tariffs and software restrictions. While Trump has since softened his rhetoric, acknowledging tariff unsustainability and planning a meeting with President Xi, the underlying friction persists. Capital Economics views China's move, which controls over 90% of processed rare earths, as a strategic gambit to boost its negotiating position.

Capital Economics identifies significant US leverage points that could escalate the conflict, including control over critical commercial aviation components and the global financial infrastructure through dollar-denominated assets and SWIFT access. A notable risk for China involves its reliance on Western technology, with 90% of its laptops and PCs using Microsoft's Windows operating system. The US could also expand export controls on chips and chipmaking tools, further disrupting Chinese tech companies.

The current trade spat carries a substantial risk of deeper US-China decoupling, potentially isolating China from Western markets and technology. Capital Economics warns that China's actions could backfire, leading to severe disruptions if the US employs its retaliatory options. The overall sentiment is moderately negative and cautious, indicating high market impact due to the potential for widespread economic and technological fragmentation.

Key Decisions for Investors

• Investors should closely monitor the outcome of the planned Trump-Xi meeting for signs of de-escalation or further trade hardening, which will significantly influence market sentiment and policy direction.
• Assess supply chain resilience and exposure to potential US retaliatory measures, particularly for companies with significant reliance on rare earths, critical aviation components, or Western software and chip technologies in China.
• Evaluate the potential for increased geopolitical risk to impact portfolio holdings, considering hedging strategies against currency fluctuations or sector-specific downturns in technology and manufacturing.