Citing the need to protect national security, the US Administration has delved into a protectionist economic policy, supposedly designed to help American producers. But will Americans, the presumed beneficiaries, actually benefit from this act of economic provocation? The simple idea of trade tariffs are enough to put the market on edge and into a tailspin with the inverse happening if these fears subside. Just this week, it took a firm commitment to the ideals of global trade by China’s President Xi Jinping to calm markets, sending most indices higher more than 2%.
In a globalized world, tariffs – which have ushered in recessions throughout history - can impart serious damage to the freely flowing exchange of goods and services. So what are the true ramifications and implications of a Global Trade War and how much could stock markets suffer from the fall-out? What are the lessons we can learn from history and why is the prospect of a Global Trade War between the 2 economic powers so dangerous?
Why global trade is important and the role of the US in the international system
International trade increases the number of goods that domestic consumers and businesses choose from and decreases the cost of those goods via increased competition. At the same time, it opens domestic industries to ship their products to new markets abroad. While the consumer is oftentimes the biggest beneficiary, international trade can harm a handful of native industries that might face stiff competition in the light of open trade.
Thus, trade agreements are a difficult balance as politicians work to extract the best deal for all of their citizens, producers and consumers alike, weighing each into consideration. The problem arises when politicians begin to favor a small subset of the population and unilaterally works to extract gains while ignoring the unintended consequences of their actions. While this may be somewhat effective in a closed economic system, the negative reverberations within an open economic system can have dire economic consequences.
In order to understand what each party will bring to the trade negotiating table, one must look at whether each country is a net consumer (importer) or net producer (exporter). By and large, the United States has been a net consumer for much of its recent past and thus, have benefitted from more goods and services at cheap prices, enabled by globalized trade.
In fact, after the disastrous consequences of the Smoot-Hawley Tariffs of 1930 when America was a net producer, the lesson was quickly learned and in 1934, the US changed course and struck the Reciprocal Trade Agreements, reducing trade tariff and helping the US climb out of the Great Depression. From this point forward, US trade policy became global and strategic, culminating with the General Agreement on Tariffs and Trade in 1948, which eventually paved the path for the World Trade Organization in 1995, an organization that the US has taken a leading role to promote open and fair trade, leaning on a system of reciprocity.
To a large extent, the US has been a huge beneficiary of these accords, boosting the economy as American consumers have been able to receive and buy goods easily and cheaply in a globalized world. By comparison, more closed economies such as Russia or Cuba, which have operated under communist regimes, have stagnated with frequent shortages of basic living necessities from time to time. Since the middle of the 1970s, when the Baby Boomer generation reached peak working age (between 25-55), the US has been a net consumer with net exports currently contributing -3% to GDP.
The Primary US Exports are Machinery (including computers), Electrical Equipment, Mineral Fuels, Aircraft/Spacecraft and Vehicle. Thus, when negotiating Trade Tariffs, these are the industries that could be most vulnerable, something recognized by China as they’ve singled out Aircraft (made by Boeing) as a retaliatory tariff.
This is a precarious situation as Boeing (NYSE:BA) just recently signed a deal with China in November 2017 to sell 300 planes worth $37 billion, putting a large source of revenue in jeopardy. However, while some producers will suffer from reciprocal tariffs and others may benefit, the major loser will be the American consumer who will gradually pay higher prices, taking more out of their wallet and acting as a tax.
The ramifications of tariffs on consumers
Global businesses and organizations such as the IMF are concerned that US-imposed tariffs will eventually lead to higher prices for US businesses, which will be detrimental to end consumers. Global brands from Walmart (NYSE:WMT) to Amazon (NASDAQ:AMZN) have specifically implored the Administration to back off tariffs of Chinese imports, warning of the inevitable impact of higher prices, which are forced onto consumers. In order to maintain profit margins, companies pass-through the higher costs, leaving less money in the consumer’s wallet. A vast amount of goods bought by American consumers – ranging from Bath & Body Works products, plastic kids for toys, Nike (NYSE:NKE) shoes and Under Armour (NYSE:UAA) leggings are all sourced from Chinese-based companies.
Citing the potential fall-out from the tariffs, Hun Quach, vice president of international trade for the US Retail Industry Leaders Association commented, “There is no way to impose $50 billion in tariffs on Chinese imports without it having a negative impact on American consumers. Make no mistake, these tariffs may be aimed at China, but the bill will be charged to American consumers…..this trade tax has the potential to wipe out any gains the average American family received from tax reform.”
Unfortunately, for consumers - both individual consumers and businesses - higher import prices mean higher prices for goods. If the price of steel is inflated due to tariffs, individual consumers pay more for products using steel - such as cars, buildings and cans - and businesses pay more for steel that they use to make goods. In short, tariffs and trade barriers tend to be pro-producer and anti-consumer, a trade-off that is more pronounced when a vast majority of the population are consumers, such as in the United States.
To give a simple illustration, take an example of cars, which happens to be the largest US import, accounting for 8% of all imports. Using the supply-demand graph below, the X-axis represents Quantity (how much a car will be sold at various prices) while the Y-axis represents Price (the price at which a car is sold for a given quantity). The red line below represents in Domestic Demand, the amount US consumers will buy depending on the price – the lower the Price (P), the higher the Quantity (Q) and vice versa, the higher the price consumers will buy less.
The blue line represents Domestic Supply, how much US car manufacturers will produce at various prices – the lower the Price (P) the lower the Quantity (Q) while the higher the price, car manufacturers will gladly produce more cars. As a net importer of cars, US consumers buy more than domestic companies produce and the difference between the quantity bought and quantity produced is represented by the bold black line, with that quantity representing the amount of cars the US imports (WS).
The price at which consumers buy this car is P*, the lower price. What happens if tariffs are imposed on cars, say a 20% hike? All of a sudden, the price rises to P with the inclusion of a tariff as a car that used to cost $20k now costs $24k to purchase. Of course, domestic car manufacturers will now produce more at this higher price, represented by the shift up/right along the blue DS line to Qd.
However, it will now be more costly for foreign car manufacturers to compete and make a profit, reducing their quantity supplied, represented by the shift up/left along the red DD line. Now, the economic equilibrium is reached with the result being the SAME quantity of cars bought, but more from domestic producers and less from foreign producers, and at a higher price.
Simple win, right? Not so fast. The major loser, other than foreign car manufacturers who will now sell less, will be American consumers who must fork over an additional $4k of their hard-earned money. Sure, US car manufacturers may increase their profits, boost wages and hire more employees in the process, emitting visible hurrahs and cheers from auto unions and corporate executives of the auto industry, scoring political points with a small subset of producers.
However, the rub lies in the invisible frustrations of the US consumers – a non-organized group that doesn’t visibly demonstrate to express frustrations. Because most consumers won’t directly see or experience the ramifications of higher prices immediately nor do they fully understand the implications, it will take time to see their frustrations. However, they will feel the pinch of higher prices, ultimately leading to lower consumption as consumers change their buying habits. Instead of buying a new car, a family may either keep their old car, resort to public transportation or biking for commutes.
Or, if the consumer does purchase the car at the increased price, they’ll compromise and substitute their buying habits elsewhere, perhaps foregoing a family vacation or postponing a plan to upgrade their house. Nights out to restaurants may decrease, a new refrigerator would be put on hold and a shopping trip would be cut short. Without a limitless source of wealth and limited income, there exist real world trade-offs for consumers and businesses alike, decreasing consumption in other areas as their budget dictates.
The bottom line is that a full blown US/China trade war has the potential to do significant damage to America, potentially lowering economic growth 25% over a year, and raise inflation by nearly 50% in an extreme scenario. As the driver of the economy representing roughly 70% of US GDP, consumer spending is the engine behind US growth, in which a reduction could result in serious ramifications for the economy and stock market.
Implications on global power and stock markets
The White House has stated that it wants to reduce the US/China trade deficit by $100 billion a year, or about 20%. Meanwhile, China is not backing down, simultaneously retaliating with tariffs on soybeans and aircraft among other US products on the US while pledging to protect intellectual property and open manufacturing further, presumably to other nations.
Chinese Premier Li Keqiang said last week that the nation will further open its economy, including the manufacturing sector, and pledged to lower import tariffs and cut taxes. The underlying connotation here is an abdication of the global trade throne, with the US handing the reigns over to China to protect global trade.
The knock on US goods from retaliatory tariffs will hit close to home as US Companies in the S&P earn roughly 43% of their revenue abroad. As governments around the world become increasingly skeptical of existing trade policies with the United States given its recent actions, trade partners may respond in turn, putting at risk the system created by the World Trade Organization and historically championed by the United States.
If other countries believe protection, not national security, is the true goal, they may feel “entitled to retaliate without waiting for the World Trade Organization to rule,” according to Chad Brown of the Peterson Institute for International Economics. While markets have already declined between 5-10% over the last few weeks, CrowdThnk surveys suggest that markets may fall more than 15% should the spat escalate into a full-blown Global Trade War.
However, many variables are at play as the market calibrates the probability of outcomes between the two Superpowers, accounting for heightened market volatility. At the end of the day, should the tariffs be implemented, global growth will feel the pinch as consumers – the misrepresented, invisible actor at the negotiating table – will suffer via price inflation, leaving companies in the stock market with less marginal demand and lower profits.
This is the Second Part of a two-part series on the potentially pending Global Trade War. Read the First Part on the Reasons Why Governments Levy Tariffs and Trade Barriers.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.