Morningstar - Fall 2019 - 41

OTHER POSSIBLE SCENARIOS

EXHIBIT 2

Scenario Probabilities A new cold war is the most likely destructive scenario.
CONDITIONAL PROBABILITIES

FINAL PROBABILITIES

Trade War
14%

70%

Trade War
20%

30%

Base Case

90%

New Cold War
16%

New Cold War
80%

15%

10%

No Trade War

85%

Hot War
2%

Concessions/
Settlement
(Base Case)
68%

Source: Morningstar.

probability for a few reasons. The most important
reason is the advent of nuclear weapons, which
was arguably the key reason that the U.S.-Soviet
Cold War didn't turn into an all-out hot war.
The U.S. and China are both fully capable nuclear
powers. The potential benefits of a conventional
war for a victor are negated by the fact that the
loser can threaten to escalate to nuclear weapons.
Additionally, the logic that it's in China's best
interests to delay a destructive conflict
applies doubly in the case of a hot war. This
is because even though China's GDP has
caught up to U.S. levels (with defense spending
possibly soon to follow), these measures
capture the flow of resources. However, in
terms of the stock of military investments, China
will spend several years catching up to
the U.S. even if its defense investments begin
to exceed those of the U.S.
The situation for China will be very different
from that of Japan, which initiated war in 1941
with the U.S. with its surprise attack on
Pearl Harbor. Before the attack, the U.S. economic
embargo on Japan (crucially cutting off its oil
supply) tilted Japan's incentives drastically in favor
of war. Although we think our new cold war
scenario will be very deleterious to China's growth,

its situation will not be nearly as dire as Japan's
was. (For example, China will still be able to import
needed raw materials.)
Still, China's improvements in military capabilities
mean that war with the U.S. is no longer
unfathomable.
What Will a Benign Outcome Look Like?
Combined, we assess a 32% probability to the
three scenarios (hot war, new cold war,
and trade war) with a large deleterious impact
on China's economy. That implies a 68%
probability of a benign outcome, which we further
split into two scenarios: (1) major concessions
from China (25% probability) and (2) a face-saving
settlement (43% probability).

Of the two, we think a face-saving settlement
is more likely. First, it is the pattern that has held
for the past several decades. Nearly all of
the complaints that have been raised recently
by the U.S. have been raised many years earlier.
On most issues, ultimately the leadership
of both sides has seen it as advantageous to
postpone major changes. Furthermore, we think
that Trump is ultimately more concerned
about obtaining a domestic political win than
brokering a substantive change in China's behavior.

Concretely, we think an agreement to modestly
reduce the U.S.-China bilateral trade deficit
(say, by $100 billion, or about 25%) would be an
example of a face-saving settlement. Trump
could claim a political win from such an
agreement. However, such an agreement would be
purely cosmetic with almost zero real economic
consequence. The countries could reduce the
bilateral balance merely by redirecting commodity
flows (such as oil and gas, which the U.S. is
increasingly exporting) from other countries,
leaving the overall U.S. export or Chinese import
levels unchanged relative to a counterfactual in
which the negotiated agreement never took place.
In terms of envisioning a major concessions
scenario, we would first look at high-importance
issues where both countries have a clear
alignment of interests (such as North Korea).
Also, there are some issues where the countries
perceive a strong conflict but where we think
there is latent alignment of actual interests,
including Made in China 2025 and cyberwarfare.
Overall, given historical examples of great
power competition, we think the U.S. and China
have about an average ability to reach
a long-lasting major-concessions settlement.
Return to Status Quo
Five hundred years of history indicate that conflict
is the norm when a rising power meets a
ruling power. Such a meeting is occurring today,
as China's GDP surpassed that of the U.S. in
2014 in purchasing power parity terms. However,
we think the chances of a GDP-damaging
conflict occurring, such as hot war, a new cold
war, or a trade war, are unlikely. More likely,
in our view, the two sides will reach a facesaving settlement that effectively is a return to
the status quo economically but that gives
a political win to Trump. Still, the chances of some
type of conflict between the two countries
are significant enough for us to adjust our 10-year
China GDP growth forecast down to 3.25%
from 3.5%. K
Preston Caldwell is an equity analyst with Morningstar
Research Services.
Stephen Ellis is a strategist with Morningstar
Research Services.

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Morningstar - Fall 2019

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