I believe political bias is interfering with the accurate dissemination of information on how the tariffs on China will impact the U.S. economy. Those supportive of this tariff suggest it will substantially increase GDP while those opposing say it will significantly reduce GDP. So which is it?
Well, the answer is rather unclear. The GDP impact depends on a highly complex web of economic interactions that could lead to either side being correct depending on what assumptions are used and what retaliatory actions result. In order to cut through the political bias, it is important that we understand the underlying mechanisms.
The impact of tariffs is of high importance to market participants as it directly impacts which way the market moves, so let us try our best to get to the bottom of this issue in as politically neutral of a way as possible.
As we know, the shorthand for GDP calculation is CIGX, with the acronym standing for:
C: Consumption (personal consumption expenditures)
I: Investment (gross private domestic investment)
G: Government (government consumption and investment)
X: Net exports (exports minus imports)
The tariff on China will likely impact (directly or indirectly) all 4 of the GDP inputs to varying degrees. Let us go over the qualitative reasoning for its impact on each variable.
Consumption spending will likely go down as a result of the tariff. If we look exclusively at the consumption of Chinese goods, the increased expense of consumption will reduce the volume of purchases. Some purchases will be redirected and others will be foregone. Those that are redirected will go to either domestic purchases or imports from a different country.
Overall, the C in CIGX will be reduced by the magnitude of purchases that are foregone. It will not be reduced by the purchases that are redirected domestically or abroad.
Domestic investment (the I in CIGX) will likely increase. To the extent that the supply chains of domestic companies are interrupted, some will replace the supply with other sources. Any moves toward made in U.S.A products will increase investment in the production of those products, while moves to other import sources such as other southeast Asian countries will have no impact on the I in GDP.
Government spending will likely increase in a magnitude approximating the tax revenues generated by the tariff. I suspect this will not be all that substantial as most of the purchases that would generate tariff tax dollars are likely to be redirected to other non-Chinese goods that are not subject to the tariffs. In other words, tariff tax dollars are going to be far smaller than current imports subject to the tariff multiplied by the % of the tariff.
Net exports will likely go up. To the extent the tariff deters imports, the quantum of net exports (exports minus imports) will rise. Purchases that are redirected domestically will reduce imports while those that are redirected to other countries will have no impact on imports.
So, qualitatively we have.
C ↓ I ↑ G ↑ X ↑
Whether this is overall positive to GDP will be determined by a set of yet unknown assumptions with the biggest ones being:
- The portion of C that is foregone rather than redirected.
- The portion of deterred imports that turn into domestic purchases versus imports from other countries
- The extent to which companies move their supply chain to U.S soil.
I suspect that the tariff, in isolation, is positive for GDP. Consumers looking to buy a product are unlikely to forego purchases rather than switching. If one is buying a pair of jeans that is now more expensive because it was made in China, they will simply buy the pair of jeans that was made in some other country. Thus, I believe the negative hit to C will be significantly smaller than the collective positives on I, G and X.
Generally speaking, tariffs benefit the GDP of the country imposing the tariff at the expense of the GDP of the country on whom the tariffs are imposed.
Does this mean the tariffs are good and that GDP will increase from the tariff on China?
Tariffs usually result in some form of retaliation. This could come in the form of China increasing the scope or magnitude of their tariffs on the U.S. or more direct retaliation against American companies operating in China.
Any retaliation would likely hurt the GDP of the U.S. China putting tariffs on the U.S would decrease our exports, particularly those coming from the agricultural sector. Thus, retaliation could easily undo the benefits to GDP and could possibly more than undo the benefits making the trade war a net negative to GDP.
Given the extent of the unknowns, it is far to early to say whether the impact of the tariff on GDP, along with the ripple effects, will be positive or negative. It behooves us, however, to understand the equations and mechanisms by which it impacts GDP such that we can better react as the hard data comes in. It is of extra importance to know the underlying mechanisms here because there is no historical data that we can reliably point to.
We cannot know the GDP impact of historical tariffs because there is no counterfactual and the amount of retaliation will be different in each instance.
Size of impact
In 2018, the U.S imported $539B from China (data from U.S census). To get a sense as to the scope of this, we can compare it to overall GDP shown below.
Overall GDP as of the first quarter of 2019 was tracking at about $21 Trillion. Thus, Chinese imports are of a size that is about 2.5% of GDP. Exports of ~$120B to China make our trade deficit with China $419B which makes up the bulk of the negative net exports figure shown in the graph above.
Given that the difference between a strong economy and a mediocre economy is only about 100 basis points of growth in GDP (3% growth versus 2% growth), there is potential for a trade war to have a significant impact on the U.S. economy.
There are so many moving parts here that I am not even attempting to predict an outcome. Instead, let us define the parameters of what good and bad outcomes look like.
Bad outcome – high retaliation with no resolution
Reflexive mirror image tariffs are generally worse than no tariffs. Ceteris paribus, the hit to exports will counteract the reduction of imports, but there will be a frictional cost for companies in redirecting supply chains for which there is no offsetting positive. If China retaliates hard and no agreement is reached for an extended period of time, I suspect it would be a net negative for the GDP of both the U.S. and China.
Given that China is more reliant on trade from the U.S. than we are on trade from China, the hit to Chinese GDP would be bigger than the hit to U.S. GDP, but that doesn’t really help anyone. This is not a zero sum game and the Chinese stock market falling further would do very little to help those invested in the S&P.
Ideally, the tariffs will be used as a tool to get to a state of free and fair trade in both directions with China. This would be superior to the situation prior to the trade war in which the U.S was providing fair trade while China was arguably not engaging in fair trade.
Bi-directional fair trade would result in a significantly smaller trade deficit largely through higher export volume than prior to the trade war. Both the U.S. and China would be better off in this outcome than in the reflexive mirrored tariffs outcome. The U.S. would also be better off in this outcome than prior to the trade war, while China would be in a less advantaged positioned than prior to the trade war.
Summing it up
I think the key in portfolio management regarding the tariffs on China is to stay humble. The network of interactions is too complex with too many uncertainties and variables to fully understand so the outcome is a true unknown. Stay diversified and consider asset classes that are more insulated from trade outcomes.
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