Challenge

Envision a worst-case trade war scenario, with tensions between the US and China finally boiling over. In a series of escalations, the superpowers ban bilateral trade, sending supply chains into disarray and shaping a new global economic landscape.

While an all-out ban is highly unlikely, the trade relationship between China and the US is poised to get worse before it gets better—the US has already implemented tariffs on chips, cars and critical minerals, and China has responded in kind. The world watches and wonders: What are the third-market implications of the trade disruptions to come?

A recent PGIM survey found that a US-China bilateral trade ban—a low-probability event with outsized potential to derail markets—is a top tail risk for institutional investors in Australia. This concern is not surprising in a country that’s hyper-focused on its ties with China, its largest trading partner.

“For Australia, China has been the goose that laid the golden egg,” says Dr. Jeffrey Wilson, Director of Research and Economics at the Australian Industry Group. “Iron ore alone is a third of our exports—$150 billion. In Western Australia, 40% of the government’s revenues come from iron ore royalties. Every road, every school—40% of that is paid for by the Chinese steel industry.”

 

Impact

In an escalated US-China trade war, industries with opaque supply chains could pose the biggest risk, says Wilson.

Corporations and governments have already zeroed in on risks for key industries like semiconductors, electric vehicles, rare earths and pharmaceuticals. But Wilson cautions that they may be overlooking medium-sized businesses with dependencies that could trigger social upheaval—think the toilet paper shortage of 2020 or the baby formula crisis in 2022 in the US.

“Because of those complex global supply chain interlinkages, it’s a morass of unknown unknowns,” Wilson says.

Australia experienced these unexpected consequences firsthand when Covid-19 lockdowns disrupted its trade with Asian partners, and manufacturers faced sudden shortages of vital imports. The country’s processed food industry was almost brought to its knees because of a dependency on plastic wrappers that all came from one overseas industrial district.

Those pandemic disruptions, coupled with Australia’s own experience with Chinese trade sanctions, forced the country into what Wilson considers to be a smaller-scale dry run of the scenario that many nations would face amid a bilateral US-China trade ban.

“There was this view that China’s the big market; there was no alternative,” Wilson reflects. “Some of our products were running 80% to 90% dependence on China. To have that disappear overnight was considered existential.”

For many Australian companies, the circumstances proved far less dire than expected—a huge amount of trade diversification helped maintain cash flow. If the US and China enacted bilateral trade bans, other nations would likely follow Australia’s playbook, looking to Vietnam, Thailand and Indonesia as alternatives.

As bilateral trade bans could dampen demand for exports—such as a steel ban impacting iron ore—Wilson says that these diversification efforts are critical.  Only countries that do this successfully will emerge from such a crisis unscathed.

 

Takeaway

“Australia is a bit of a canary in the coal mine,” says Wilson. “If similar dynamics happened in your market or sector, what would that look like? What does the Australian case mean for our global supply chain?”

In light of US-China trade relations today, investors should be watching that supply chain factor closely, he says. Fortunately, the challenges of the pandemic and early-stage trade disputes have already inspired an emphasis on supply chain management and diversification—setting up sectors to better withstand escalations in the future.

“The first question boards and investors are asking is, What’s your supply chain plan for the next five years?” Wilson says. “This gets us a bit more ready for some of these black-swan tail events.”

The biggest hurdle inhibiting preparation is the lack of incentive for knowledge-sharing, Wilson says—governments don’t want to tell businesses that they’re war-gaming World War III supply chain management, and businesses don’t want to show their hands, either. But that cooperation is critical to maximize resilience.

“It’s a gold rush at the moment with everyone doing these exercises and finding information with commercial value, but it’s very fragmented,” says Wilson. “The market doesn’t have a good idea of what the risk is—they don’t know what the companies know. The companies don’t know what each other knows. There’s a lot of ‘fog of war’ that’s working against us.”