While the Trump administration’s plan to use tariffs on steel and aluminum was intended to be China-centric in scope, the plan morphed quickly into an ill-defined shot across the respective bows of friend and foe alike. From Japan to South Korea to Brazil to Canada to Germany, here-to-for allies of the US all fell precipitously into the clutches of the administration’s fast-closing dragnet.
The threat of unilateral, muscular action sent spasmatic quivers down the spines of both market players and trade experts alike dreading the fact that the administration’s actions would have the exact opposite effect in the real world - that of undermining the collective momentum of business and countries alike holding long-simmering grievances with alleged predatory Chinese trade, investment and business practices.
The S&P 500 (orange area) fell 2.5%, sliding into negative territory for the year. Japan’s Nikkei Index (black dotted line) fell just over 4.5%. The Hang Seng and Shanghai indices fell 2.5% and 3.4%, respectively. Boeing (NYSE:BA), Caterpillar (NYSE:CAT) and Deere (NYSE:DE) lost 4.1%, 5.2% and 5.7%, respectively. German car makers BMW (OTCPK:BMWYY) and Daimler (OTCPK:DDAIF) are down 3% and 5% since the beginning of March.
Utility stocks were the only sector to escape Friday’s market deluge. Treasury notes (green line) and gold (gold line) rallied strongly (see Figure 1, below). Across the world, the better part of a trillion dollars in market value disappeared - a disproportionate price to pay for 34.6 million metric tons of steel, about $30 billion in market value, through the end of 2017.
Figure 1: The 10-Year Treasury Note, SPDR Gold Shares (GLD) and the Nikkei against the S&P 500 through Friday’s market close
As the scope of the plan slowly began to take shape, market concerns only grew. Through the use of spurious economic determinants justified on verboten national security grounds - the administration cobbled together a unilateral tariff regime dismissed by most economists as absurd. The US already produces about 2/3 of its total steel use. Currently, the US has but a fraction of the iron ore reserves of either Russia or China.
US steel production based on a tariff regime would vastly speed up the depletion of the country’s existing iron ore reserves. An autarkic US steel industry would make US steel companies, as well as the products of domestic consumers of steel, hopelessly uncompetitive in world markets. As for aluminum, the last time bauxite was produced domestically was some 30-years ago. The US is currently completely dependent on foreign sources for bauxite.
Making US bauxite production commercially viable through a tariff regime would be well-nigh impossible. Further. Canada, Japan, Germany and South Korea, all major steel producers, host US troops under long-standing armistice and defense treaty arrangements--makes these countries curious national security threats. South Korea is key to any future agreement to the nuclear standoff on the Korean peninsula. The use of temporary exemptions for Canada, Mexico, Australia and the EU further muddles any remaining tread of national security logic by linking countries to future trade concessions.
If other countries believe that protection, rather than national security, is the basis of the US tariff regime, the US program provides every incentive for other countries to respond in kind - now and in the future. And it goes without saying that tariffs will undermine the current rule-based global organizational base while irreparably fragmenting global supply chains. Manufactured goods today draw on inputs from around the world making autarkic production all but impossible. Disruptions to the web of global supply chains come at incalculable economic cost - to both company and consumer.
Of course, the flip side of any such unilateral action that makes both market actors and most economists cringe is the quite justified fear of provoking retaliation. China is inextricably tied to myriad supply chains the world over. Its finished products are sold in the world’s markets almost without exception.
Its investment arm stretches across the seven continents, influencing decision makers, building infrastructure, offering loans, know-how, technical assistance—and opening markets for Chinese goods and services. China’s sheer economic reach make a tariff regime launched by a single country—irrespective of political or economic heft—an exercise of sheer futility.
Few would quibble with the reasons behind the continuing glut of low-cost steel on world markets over the past five years that have already forced many a steel producer into receivership at the cost of countless jobs across the developed world. Few would quibble with the Chinese penchant for gaining access to technology as a condition of market access in China. Few would dispute the Chinese regulatory regime that runs roughshod over western intellectual property and patent rights.
Few would argue that China has manipulated the value of its currency for market purposes. Many would argue that the inclusion of China in the WTO in the hopes the country would embrace more globalist values of international trade has failed. Yet precious few outside the current administration would agree that any of these persistent problems can be solved through the use of tariffs—despite the one-off political appeal.
Since WWII, the US and its allies have forged a global economic and security regime based on the notion that international trade is one of best means to minimize the outbreak of military hostilities. Simply stated, nations connected by commerce have an overriding interest in maintaining peace. The World Trade Organization (WTO) was created as the institutional keystone of the regime whose mission was to collectively reduce the impediments of international trade on the flow of goods across international borders.
Tariffs prior to the war averaged 20% to 30%. The WTO process reduced that average to 2.1% in Japan. The weighted average tariff for the US dropped to 2.4%, while the collective nations of Europe averaged 3% under the WTO paradigm. For China, who joined the WTO in 2001, the weighted tariff average came to 4.4%, a rate that acknowledged at the time the country’s developing economy. Bilateral and regional trade agreements have pushed average weighted tariffs on the flow of goods across international borders even lower, bolstering cross-border trade flows, household wealth and economic growth.
Much of the work to reduce the global impediments to trade across international borders is now under siege. Recent policy disagreements with America over its policy in Iraq, Afghanistan, the Middle East, defense spending typically found adherents in Europe and the rest of the developed world on both sides of the issue. This time, it appears to be different. The Trump administration is not just staking out a single, defining position that runs contrary to conventional thinking of the post-WWII era.
Invoking policy disputes over cross-border taxation, denying the impact of climate change, undermining the nuclear deal with Iran, walking away from multinational trade pacts, undermining the WTO, questioning the relevance of western defense organizations—are fundamental attacks on the very rule-based international system America has painstakingly built over the past 60+ years.
Of course, Donald Trump is not the only president to try his hand at protecting a basic industry undermined by foreign cost structures. Barak Obama’s 2009 decision to impose a tariff on low-end Chinese tires quickly comes to mind. Imported tires from other countries jumped 20% and the price of all tires in the US market rose on average 18% as a result. The additional cost to US consumers came to an estimated $1.1 billion, or about $900,000 per US tire job saved.
The penultimate example of tariffs gone wrong goes to GW Bush’s March 2002 own decision to tariff imported steel, offering up almost a carbon copy of the current Trump iteration. Slapping tariffs from 8% to 30% on a variety of steel imports, steel coming from targeted countries unsurprisingly plummeted. Equally unsurprisingly, steel imports from non-targeted countries surged. Overall, steel imports increased 3% over the 15-month period through December 2003 while employment in US steel production remained pressured.
By December 2003, after a successful EU challenge in the WTO, the US had abandoned its tariff regime. The 15-month program saw the loss of an estimated 200,000 US jobs in steel-consuming companies had been lost - more than the total number of steel producing jobs in the labor force for the period.
Undeterred, on Friday of last week, the Trump administration followed suit. Citing national security as described under section 301 of the Trade Act (1974), the Trump administration instructed the government to begin the process of responding to China’s alleged predatory business practices. Robert Lighthizer, the US trade representative (USTR), outlined a unilateral $60 billion tariff package with a market value of about 16% of the $375 billion trade deficit the US posted with China in 2016, aimed squarely at China’s “Made in China 2025” program.
The regime specifically targets robotics, aerospace, maritime and high-speed rail equipment as well as electric vehicles and biopharma products, all integral components of Chinese economic development program through 2025. Symbolism aside, much of these strategic areas in the Chinese economy are in development stages with few physical products to show for export markets outside of advanced electric car batteries and some networking telecommunication equipment.
None of these items are in the export mix for US markets. China’s main exports still concentrate in low-end goods such as appliances, clothing, footwear, furniture and toys. Electronic devices are a notable exception, but even here the caveat is glaring. Many of these electronic devices, iPhones in particular, are largely manufactured elsewhere, with only the final finishing touches applied on Chinese soil.
The initiative also set into motion an order for the Treasury Department to come up with a regulatory regime to monitor Chinese investment in these sectors within 60 days in an effort to check Chinese efforts to acquire US technology by buying US companies and investing in US tech start-ups.
The regime would add enhanced regulatory structure to the standing Committee on Foreign Investment in the US (CFIUS), which is charged with evaluating and protecting US national security issues as it relates to foreign direct investment flows into the US. Chinese FDI in the US was about $30 billion last year, down from a record $45 billion in 2016.
The temporary exemptions granted to the EU, Canada, Mexico, Australia, South Korea and Brazil to date could be subject to steel and aluminum quotas before the 60-day period ends if deemed appropriate. What is to be achieved by further negotiations in front of the 1 May deadline was not readily apparent - not to mention legally difficult to achieve outside of a formal free-trade agreement - adding further uncertainty regarding the breadth and scope of the US tariff regime.
The Trans-Atlantic Trade & Investment Pact (TTIP) has been frozen since the US election while America’s participation in the Trans-Pacific Partnership (TPP) was actually canceled in the first week of the Trump administration. A separate tariff agreement is not compatible with existing WTO rules. Steel exporting countries of Japan and Russia did not win temporary exemptions that, along with China, represent the three targeted countries at the moment.
A quota regime would likely be necessary to minimize the transshipment of tariffed items through exempted countries—a contingency that was a constant nettle in GW Bush’s 2002 tariff on steel from the EU and Japan. Exemptions at the time on steel originating from Canada, Mexico, Israel and Jordan saw the price value of their exports to the US soar due to the market distortions created by the tariff regime. A quota regime is much more benign than a tariff as country quota producers benefit from higher prices due to the artificial restrictions on supply caused by a quota system.
By contrast, a tariff regime, tariff taxes at the border revert to the government administering the tariffs. Canada and Mexico together provide 43% of the $30 billion in US steel imports through the end of 2017 as prices on steel and steel products originating from these two countries will surge. Exemptions could be revoked at any time.
In a parting shot of irony or cynicism, the USTR was instructed to file a case with the WTO in an effort to halt Beijing’s practice of forcing foreign investors to transfer technology to China as an entrance fee to the Chinese market. With this filing, the US hopes to draw in both companies and countries that have fallen victim of China's broad policy requirement - the sole collective measure of the package. With the hopes of gathering a united front on the issue amongst the very nations the US has threatened with stiff tariffs appears surreal.
And the fact that the US would engage the auspices of the WTO at the same time it works tenaciously to render the institution all but irrelevant at almost every turn, provides one more example of just how far the Trump administration has strayed from the globalist path of US policy in the post-WWII era.
China’s response has been as measured as it has been politically surgical. The ministry of commerce outlined a $3 billion in US imports, slapping a 10% tariff from fruits and nuts from California and a 25% tariff on pork from Nebraska and other Midwestern states where political support for Trump ran strong in 2016. A 25% tariff was also placed on recycled aluminum, offsetting the 10% tariff on imported aluminum into the US. The initial Chinese list included 128 US products, about 2% of the $130 billion in US imports through the end of 2017.
China’s initial list of targeted US imports was noteworthy more by the products that were not on the initial list. Soybean exports, which came to $12.4 billion last year, were not included. Neither were electronic devices like iPhones and Kindles, which, while mostly assembled elsewhere, undergo final assembly in China. Sorghum, aircraft from Boeing, earth moving machinery from Caterpillar, farm equipment from Deere were all missing—as was any mention of sales of US Treasury notes. With $1.17 trillion in US treasury debt in its possession through the end of January, China retains plenty of room to maneuver.
The fallout from the unilateral US tariff regime could be broadly felt throughout the world. China accounts for about 30% of Australia’s exports, which includes iron ore - a prime component of steel. The Australian dollar has fallen about 5% since February. In Japan, the Nikkei plunged 4.5% while the Tokyo stock exchange, where most of the corporate profits are generated from export sales - including both the US and China - fell almost 4% through Friday’s market close.
Meanwhile, the yen surged to ¥104 to the dollar as investors underscore the safe-haven value of Japanese assets while corporate profitability sinks into doubt as the Japanese fiscal year draws to a close at the end of the month. Ironically, while Japanese steel exports to the US account for about 5% of Japanese production, the steel that the US doesn’t import due to its tariff regime will likely flood Asian markets, applying downward price pressure on steel throughout the region.
Emerging market countries like Taiwan, Korea, and Malaysia would become highly vulnerable to the escalation of US tariffs regimes aimed at China. Escalating trade barriers could provide more than ample excuse for capital outflows to seek safe harbor vehicles outside the EM space, placing South Africa, Russia and Indonesia at risk.
Turkey, defying investor expectations, posted a 7% GDP growth rate last year, aided largely by government subsidies geared toward smoothing over any lasting remnants of the 2016 coup attempt. Inflation is again in double digits, currently at 12%, while its current account deficit continues its upward climb of old, tipping the scales at $7.1 billion through the end of January. This equals about 6.1% of projected GDP through the end of the year - making Ankara and its economy very vulnerable to changing global economic conditions.
With elections slated for March and November of next year, President Erdogan is fully expected to push economic growth at full tilt irrespective of the economy’s potential for overheating. The lira is already at a three-month low against the lowly dollar and at historic lows against the euro. A halt or slowdown in foreign flows critical for rolling over the country’s bulging short-term current account debt load cannot be dismissed.
Figure 2: Canadian Dollar and the Mexican Peso
Mexico racked up a trade surplus of roughly $172 billion in goods with the US through the end of 2017. Mexico, an integral member of the 24-year old NAFTA agreement has, along with Canada, received tentative exemptions from US tariffs - pending a concluding agreement to the current round of negotiations. The Mexican peso (purple line) is up just under 7% against the dollar YTD (see Figure 2, above). The peso was sold heavily during much of the US presidential campaign with the ebb and flow of the currency following closely to the ebb and flow of candidate Trump throughout the electoral cycle.
With Trump’s surprise electoral college victory, the Mexican peso plunged to its lowest post in at least ten years in first weeks of 2017. The current peso rally has erased much of the losses of the recent past against the dollar as many of the market concerns regarding the currency have already been priced in. Still, there are few countries in the world that are more dependent on trade with the US than Mexico.
The likelihood of the left-wing, sharp-tongued populist Andrés Manuel López Obrador now holding a double-digit lead in the polls leading up to Mexico’s July presidential contest going toe-to-toe with the right-wing, sharp-tongued populist Donald J. Trump is all but inevitable - possibly leaving the future of NAFTA dangling in the breeze.
As for the Canadian dollar (green line), the angst over trade within NAFTA coupled with benign economic growth data in the 4th quarter have caused the loonie to fall below both its 50-day and 200-day moving average since mid-February, despite a falling unemployment rate and strong job creation. The Bank of Canada has kept interest rates steady while increasing the volume of its warnings on trade. This leaves the currency’s 50-day trading measure poised to crash through its 200-day measure if current trends continue (see Figure 2, above).
Foreign direct investment (FDI) inflows to Canada has fallen for three consecutive years, slack that has more than been made up by increased FDI flows to the United States, which is up 12% through the end of 2016. With the passage of the Tax Cuts and Jobs Act (TCJA) in December, FDI flows to the US could follow a similar path for medium term. The main reason for the decline in FDI inflows to Canada stems largely from the relative weakness of the country’s mining and energy sector, which attracted about $5 billion of inflows through the end of 2016, far short from the peak year of 2013 when FDI to the sector hit $13 billion for the year.
The main source country of FDI to Canada comes unsurprisingly from the US where tax uncertainty and weak demand has weighed on corporate investment decision making. For both Canada and Mexico, uncertainty over trade and politics are encapsulated by the ongoing renegotiations of the NAFTA accord, which is now in its fifth round of talks. The continuing trade saga creates the biggest headwind to economic growth for both countries moving forward. And after five tough negotiations, an agreement has yet to be concluded.
At even greater risk is that of the beggar-thy-neighbor German economic model that now sports a current account surplus exceeding 8% of GDP, the largest in the world. Germany, as a member of the EU does not have an independent trade policy. As a member of the eurozone, Germany doesn’t have a national currency. Only recently, after six months of political wrangling after its national elections in September, Germany finally has a government.
Through the end of 2017, Germany was the world’s fifth largest exporter of steel at 19.5 million metric tons with the US importing about 5% of that total—a total that now over twice that of China. Of course, German exports of steel is but a side-show for the volume of German cars exported to foreign markets. Germany ranks first in the world in total automobile exports with $151.9 billion or 21.8% of the world’s total through the end of 2016.
Little wonder that the German DAX plunged in late January as the first whiff of possible US tariffs on steel and aluminum hit the airwaves. Since then, the DAX (green line) has plunged through both its 50-day (blue line) and 200-day (red line) moving trade average, triggering a rarely seen death cross where the DAX 50-day trading average drops below its 200-day trading average (magenta box). Technically, this is a sign that downward pressure on the DAX is likely not finished and could intensify in the coming days and weeks as US policy become clearer. The YTD performance DAX is well below that of the S&P 500 (orange area).
The DAX closed down 1.4% at the end of Monday’s trading with automobile stocks leading the charge through the exits. An appreciating euro (black dotted line) adds further pressure on the German export model as growing US protectionism continues to exert downward pressure on the value of the dollar while an appreciating euro makes German exports more expensive in world markets. The dollar (gold dotted line) has lost 15% against the euro over the past 12 months (see Figure 3, above).
Within hours of imposing a plethora of tariffs on Chinese goods coming into the US, the USTR offered the EU a temporary reprieve pending further negotiations. The exemption came after a two-day visit to Washington by Cecilia Malmstrom, the EU trade commissioner. While US tariffs on EU products were granted a temporary stay, the Trump administration’s determination to rectify lopsided trade imbalance with the EU, which exceeded $100 billion through the end of 2016, remains undiminished.
The price the EU could still be asked to pay in future negotiations is likely to be stratospherically high—a drastic reduction in the euro-zone's and Germany's trade surplus with the US and perhaps the rest of the world, which would not only leave the EU export model in tatters - but would likely send the EU into a protracted economic tailspin. There would also be strong pressure exerted for the EU to hit the long-ignored 2% of GDP defense spending threshold for NATO.
Currently, only five of 22 EU member countries that are also members of NATO meet or exceed the 2% defense spending target: Greece, Estonia, the UK, Romania and Poland. Germany, the largest EU economy, spent just 1.22% of its GDP on NATO contributions through the end of 2017. Europe’s pending digital tax, a response to the Tax Cut and Jobs Act (2017), would also likely be stopped dead in its tracks. Morality aside, US trade policy now comes equipped with a neo-mercantile truncheon. The Trump administration appears to be creating consequences rather than engaging in negotiations. The fallout remains incalculable.
Figure 4: The Barclays US Aggregate Corporate Bond Index against the US 10-Year Treasury
Another area of concern comes from the bond space. The 10-year Treasury Yield Index (orange area) is well above its 200-day (thin green line) moving average for the year, with strong market momentum to the upside. At the same time, the Barclays US Aggregate Corporate Bond index (thick green line) has fallen off precipitously YTD, with its 50-day moving average (blue line) crashing through its 200-day moving average (red line) for the second time, spaced almost exactly a year apart (magenta boxes).
Both moving average measures are key market momentum indicators. This is not a coincidental event. The option adjusted spread for the US aggregate corporate bond index, a present-value, option-based measure of assumed risk relative to comparable government yields, has not been above its 200-day moving average (red line) since March 2016 (see Figure 4, above). Through the end of February, the spread between BBB-rated corporate debt and comparable Treasury yields averaged 48 basis points wider than the A-rated spread, according to Bloomberg Barclays indices.
Over the past 15 years, that gap has averaged 59 basis points. The slice of the corporate debt space that is rated BBB, one notch above speculative grade—is now 48% of the investment grade market, according to ICE/Bank of America Indices. This is a bearish signal on forward credit risk originating at the time due to international worries about untoward levels of debt propping up the Chinese economy, the excess from which was a primary contributing factor in the country’s equity market crash the year before.
More recently, the signal is reflective of the heavy issuance of debt in the corporate space that took advantage of historically low borrowing costs of the past decade since the Great Recession of 2007. Record levels of corporate debt issuance now mixed with increased government issuance of debt to fund burgeoning gaps between revenue collection and spending authorization present the first tell-tale signs of crowding out private sector borrowings, which is now in the mid-innings of play in the secondary market.
The funding pool for short-term debt may also have shrunk as repatriated cash from abroad enters the country and is spent, rather than tied up in short-term investments. Meanwhile, US savers are directing their savings away from banks and cash equivalents and into US Treasury instruments—a similar response in the 2007 financial crisis here in the US and the 2012 financial crisis in Europe. The impact weighs on new issuance pricing with likely wider prices concessions than would otherwise be the case.
The current levels of corporate debt issuance this late in the current business cycle could be the makings of a looming credit crisis as the Federal Reserve remains firmly on track with tightening monetary policy, sending borrowing costs steadily to the upside. After the March FOMC meeting, 7 of 15 voting members of the Committee are projecting four upticks in the federal funds rate through the end of the year, up from 4 of 16 votes in December.
The spread between the 2-year and 10-year Treasury, already at 55 basis points at Friday's market close (23 March) is poised to flatten further. At a reading of -0.78 for the week ending 16 March, financial conditions remain uber-loose, according to the latest National Financial Conditions Index measure, but tightening all the while from the year ending measure of -0.87. We are still very much in the beginning stages of the post-LSAP normalization cycle. Monetary policy has a lot of tightening to do to catch up with the current level of economic potential.
Whether the Trump administration manages to start a trade war or whether the events of the past few days are contained to the likes of a passing tempest depends on what happens next. History has not smiled on those countries that have sought to protect domestic industries from the ravages of cross-border competition in its many forms. Cross-border commerce suffers, jobs are lost, household income declines and price increases for consumers - are all common results of protectionist policy initiatives over the course of time.
The real risk comes from escalation, the replacement of a predictable, rules-based structure of resolution with one determined by whimsical, narrow national interests. The latter moment has not, at this writing, arrived. Unfortunately, the seeds for such an outcome appear to have been sown.
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