Balanced Trade With China Is Bad News

Includes: ASHR, FXI, IEF, RTH, SHY
by: Austrolib

The March 1 deadline for a trade deal with China before US tariffs rise to 25% on $200B in Chinese imports is fast approaching.

If no deal is struck and tariffs go up, this is very bearish for equities, especially US retailers and China ETFs.

If a deal is struck that actually balances trade between the US and China, this will be very bearish for US Treasuries and ultimately, inflationary.

Investors can hope for a nominal deal that will take tariffs off the table, but keep the balance of trade as is, which is actually the most likely outcome.

We are now one month away from the March 1st when US tariffs on Chinese goods will jump to 25% from the current level of 10%, on $200B of imported Chinese goods. China and the United States have one month to settle their differences or global trade will be heavily disturbed. At first glance, one would think that this is a binary event. If a deal is struck, that's good for equities. If no deal is struck and tariffs go up to 25%, that's bad. I believe this is the wrong way to look at it. Rather, if a deal is struck that changes the balance of trade between China and the US, this will be bearish. If no deal is struck and tariffs go higher, this will be bearish as well. So, what can investors hope for? An announcement of a deal that will take additional tariffs off the table, but that has little to no effect on the current trade balance between the two.

True, short term, news of tariffs increasing to 25% on $200B worth of imports would cause stock prices to crater. Conversely, any deal announced that will take tariffs off the table will almost certainly give stocks, especially US retailers dependent on Chinese imports (RTH) and Chinese ETFs (FXI) (ASHR) a big temporary boost. However, if the deal actually does change the current balance of trade between the US and China, it would be Treasury securities that would suffer the most and it would only hurt equities in the long run.

In order to explain why, first let's examine the term "balanced trade". It sure sounds nice and it can score a politician a lot of points, but it's really a completely superfluous term. It's like saying "free gift". All gifts are free. That's why they're called gifts. So too, all trade is balanced. That's why it's called trade. It has to be balanced in order for two parties to agree to execute it. But, claim the Mercantilists, how can we claim that trade is balanced when "trade deficits" with China are at an all-time high?

Well, what's my trade deficit with the local supermarket? The only reason I go there is to import groceries into my home and to export currency to the supermarket. Every time I go there, the trade deficit between myself and the supermarket gets worse and worse. If I wanted "balanced trade" in the mercantilist sense between myself and the supermarket, I would have to sell the same amount of food to the supermarket as the supermarket sells me. But what happens if I do that? It means I'd have to spend my time and resources growing food, and so would everybody else who shops at the supermarket. The division of labor would break down. So would economic life as we know it on planet Earth.

Really, trade between myself and the supermarket is balanced even though we have an ever-expanding "trade deficit" because the money I pay them enables them to continue doing what they are good at and by not having to grow food allows me to continue doing what I'm good at. It's a simple comparative advantage we all learn in Econ 101.

Replacing myself and the supermarket with the US and China, the US ran a "deficit" of $375B in 2017. What happens to the "unbalanced" money? Whereas the supermarket reinvests the money I pay them in their own business of distributing food, the Chinese reinvest the dollars the US pays them back into US Treasuries, which means the Federal government gets the money right back again and spends it. That is essentially why trade between the US and China is already balanced. Because the dollar deficit is sent right back to the US anyway and consumed by Congress.

Now imagine that we have "balanced trade" between the US and China in the mercantilist sense. That means the Chinese have no extra dollars to buy Treasuries with, so they stop buying them. The federal government then needs another way to finance its budget deficit. If other countries pick up China's slack here, that would simply mean that the US trade deficit with other countries would expand to compensate for the now balanced bilateral trade between the US and China. The US balance of payments globally would not change.

So, why even focus on China at all? Why not focus on the US balance of payments with the entire world and try to "balance trade" globally? Isn't that even better than bilateral balanced trade with China? If trade deficits are a problem, then China is just a symptom of globally imbalanced trade. So, let's fix that. The US global trade deficit in 2017 was $795 billion. Balance that and the US has nearly $800 billion in Treasury demand to make up for.

Congress could cut spending by $800 billion a year and interest rates would stay stable all else being equal. But we all know that's not happening. US investors could theoretically make up for some of the difference. The rest would have to be made up of by the Federal Reserve conjuring up the difference, which means more quantitative easing.

In the end, there are three possibilities with this whole China trade episode by March. A deal for balanced trade in the mercantilist sense is struck, causing a trade imbalance in the real (not mercantilist) sense and forcing the Fed to step up and buy more Treasuries (bad for the dollar and inflationary), or in the absence of that, for interest rates to rise significantly (bad for stocks) in order for domestic investors to pick up the slack. The other possibility is no trade deal at all, even nominally, and tariffs increase at the end of a credit cycle, the Fed hinting in its latest FOMC press release that this current rate hiking cycle may be over. For more on instituting tariffs at the end of a credit cycle, see Smoot Hawley.

The third possibility which I see as the most likely is that a "deal" is announced that doesn't change the current balance of trade between the US and China significantly, or at all, in practice. Trump takes credit for accomplishing little to nothing, tariffs are rescinded in celebration of a trade victory that changes pretty much nothing, and stocks react bullishly in the short term. Even if a deal is announced that actually does aim to eliminate the US-China trade deficit, the probability is that it won't in practice, and everything will go on as it was before.

The only way to eliminate the US trade deficit with the world is to balance the federal budget and run a surplus, which is about as likely as an alien invasion. Thankfully, Trump is working on the space force.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.