As we head into what is typically the slowest part of the investment year, we have markets dealing with an unprecedented situation: the US – China trade war. While much of Wall Street is on vacation in August and trading volumes seem to dry up in the summer heat, markets and investors are now being held captive by escalating tariffs and rhetoric out of Washington and Beijing. Combining thin markets, lightning fast algo-driven trading and material information being released as quickly and randomly as a tweet can be tweeted, a perfect storm of market forces has been created. To weather this trade war storm and perhaps even use it to our advantage, one needs to understand how China’s trade policies developed and how they are managed. Fortunately, with just a brief history lesson and a look back at a surreal incident between a small American manufacturer and its Beijing hosts, we can get an excellent preview of how this trade war is likely to unfold.

The crux of the trade war is the US holding China accountable for its intellectual property theft and other aggressive business practices which are clearly considered standard operating procedures throughout public and private organizations in China. These operating procedures are part of a much larger protectionist dynamic of Chinese culture that stems from China having suffered through what is known as the “Century of Humiliation.” The Century refers to the years of 1839 to 1949 when the British and Japanese empires plundered China with Japan specifically carrying out numerous atrocities during World War II. Given these terrible occurrences and the deep social scars they left in Chinese society, it’s understandable why China has taken aggressive approaches to economic development as it re-established itself in the global economy. However, now that China sits atop the world economic order, these practices need to end because they are coming at the expense of its partners.

One area where China’s protectionist policies are well defined and stand out from global standards are in its labor laws. The OECD, a highly regarded and objective international organization, produces an indicator which reviews a country’s hiring / firing policies, their associated costs and then ranks them on a scale from 1 to 3.5, with 3.5 being the most restrictive. As you can see, China’s labor protection policies are essentially the strictest in the world because they are outdone only by Venezuela! To put this in perspective, France (a known labor-friendly country) is roughly twice as restrictive as the US while China is three times that of the US.

It’s these labor policies and the sense of entitlement they have created that gives us an excellent view into how an escalated trade war could play out. In 2013 an American business executive, Chip Starnes, was literally held hostage for six days by his employees over a labor dispute. Mr. Starnes company, Specialty Medical Supplies, was going through a restructuring and was going to terminate some positions and re-locate others. After severance packages were given to 30 (yes, just 30) terminated employees and others were told they would be relocated, the relocated employees began demanding severance pay as well. It was then that the issue escalated into Starnes being barricaded in company facilities by groups of employees who blocked all the exits. While no physical harm was done, although sleep deprivation tactics were used, Starnes was always allowed to communicate with his family, the US Embassy and his lawyers. Throughout the ordeal, and most troubling, is that local authorities sided with the employees and allowed the situation to continue until a new agreement was signed. As outrageous as this situation would be in any developed country, it’s a perfect example of how the “shakedown” mentality exists in China and is pervasive from high-level government trade policies all the way down through locally run businesses.

Thanks to Starnes shocking ordeal, it’s safe to assume that the civil unrest and reactions to a major corporate restructuring from the likes of Nike, Wal-Mart or GM, who employ 161K, 99K and 58K respectively in China, would be apoplectic compared to what happened with just the handful of employees in the Specialty Medical Supplies case. Then we have a more recent case of civil unrest from a trade war casualty, even though it was censored in Chinese media, but news still got through on Twitter, was when a temporary shutdown of ZTE (a known supplier of technology to China’s weapons industry, not just a telecom firm) idled 75K workers. Numerous tweets were seen that detailed workers’ feelings of frustration with the government’s inability to keep the business running. So, it’s not surprising that a deal with the Trump administration was quickly reached to get ZTE back open.

Along with IP theft being a known issue which Beijing doesn’t like to discuss, is also their fear of civil unrest. In a country of nearly 1.4 billion people who are being controlled by President Xi and his Politburo, civil unrest can’t be allowed to happen. China has made giant strides in its development over the last several decades which was made possible through authoritarian and effective leadership. However, this leadership is only possible through a satisfied and passive body of people who are willing to accept strict leadership in return for economic gains. Like the Kingdom of Saudi Arabia where the citizenry is appeased through massive social entitlements, China’s leadership needs to keep the masses happy, or they could lose their grip on power.

Looking at the potential massive civil unrest that could be unleashed from a full-scale trade war, it seems more likely that Beijing will do whatever is necessary to keep businesses open and jobs where they are. So, while there will be more rhetoric out of China as the Trump administration pushes for fair trade and fair business practices, an amicable solution is the most likely outcome. While some will argue that China can retaliate with similar actions that could cause unemployment here, the American economy with its services base and dynamic nature will be much better able to handle such retaliatory responses. There will be no hostage taking in America when corporate restructurings happen, and people will find a way to persevere as we always have.

With all this said, if we take the trade war narrative out of the equation and allow investors to focus on the excellent earnings season we’re having and the fact that the S&P is now trading at just 17.9x 2018 (versus 25x seen in the 1997-2000 bull market) blended operating earnings, we see that there are a lot of good things going for this market. Now, with a Fed saying that they are close to a neutral rate, long term rates settling in with structurally lower inflation dynamics (see third paragraph) and a healthy economic backdrop, we have a market primed for earnings growth and multiple expansion…In which case, the only things shaking will be the bears.

At the time of this posting, the author has the following positions: None

Marco Mazzocco is an associated member of T3 Trading Group, LLC (“T3TG”), a SEC registered Broker-Dealer & Member of the NASDAQ PHLX Stock Exchange. All trades made by Marco are placed through T3TG