A little tariff here, a little tariff there, and before you know it, it adds up to a whole lot. We read a contributor last year who argued the trade war was irrelevant to the market, but it seems to have taken a new toll.
Since May 5, when President Trump tweeted he was hiking tariffs to 25% on $200B of imports from China, indexes have been plunging and bonds have been rallying strongly. This (Friday) morning things are not exactly looking any better, with the markets digesting the latest tariff threat on Mexico.
It isn't simply the tariffs in themselves; it's the fear that the trade war will greatly damage world economic growth. The tariffs themselves are bad enough, though. The following is from the conclusion of a paper by three New York Fed economists which we reproduce entirely below (our emphasis):
"We estimate the cumulative deadweight welfare cost (reduction in real income) from the U.S. tariffs to be around $6.9 billion during the first 11 months of 2018, with an additional cost of $12.3 billion to domestic consumers and importers in the form of tariff revenue transferred to the government. The deadweight welfare costs alone reached $1.4 billion per month by November of 2018. The trade war also caused dramatic adjustments in international supply chains, as approximately $165 billion dollars of trade ($136 billion of imports and $29 billion of exports) is lost or redirected in 23 order to avoid the tariffs. We find that the U.S. tariffs were almost completely passed through into U.S. domestic prices, so that the entire incidence of the tariffs fell on domestic consumers and importers up to now, with no impact so far on the prices received by foreign exporters. We also find that U.S. producers responded to reduced import competition by raising their prices. Our estimates, while concerning, omit other potentially large costs such as policy uncertainty as emphasized by Handley and Limão (2017) and Pierce and Schott (2016). While these effects of greater trade policy uncertainty are beyond the scope of this study, they are likely to be considerable, and may be reflected in the substantial falls in U.S. and Chinese equity markets around the time of some of the most important trade policy announcements."
Take note of the following:
- The cost of the tariffs are almost entirely paid by households and importers (something which the IMF also argued).
- The costs don't include other potentially large costs like the policy uncertainty they generated.
- These are just the effects up until November last year. Not included are the new recent escalation rising tariffs on $200B of Chinese imports from 10% to 25%, let alone the threat to put tariffs on the remainder of Chinese imports, nor the tariffs threatened on Mexico, nor the likely retaliation of these aggrieved trade partners. For instance, China recently stopped the import of U.S. soya beans altogether and increased tariffs on U.S. imports as well.
But trade wars are easy to win, right? So these are just short-term transitional costs on a road to a better world. We're not so sure of that. Here are some other costs:
- The U.S.-China trade war has taken a toll on multinational companies' bottom lines and has injected an element of uncertainty into business planning. (Market Insider)
- A new escalation in the trade dispute between the U.S. and China would be particularly damaging to American efforts to build out its 5G infrastructure (Yahoo).
- Nearly three-fourths, or 74.9%, of almost 250 respondents to a survey held from May 16 to May 20 said the increases in U.S. and Chinese tariffs are having a negative impact on their business (CNBC).
- U.S. companies are slowing capital spending due to trade uncertainties.
- U.S.-China trade war could cut global GDP by $600 billion, OECD warns.
- U.S. consumer spending likely to slow due to tariff-induced price hikes.
- Corporate earnings growth is clouded by uncertainties.
- Recessionary risk in next 12 months may be 60%, per the bond market.
- The trade war has cost U.S. equity markets $5T in foregone financial return, according to Deutsche Bank.
- Estimates indicate that the average American household will pay at least $500 extra this year because of tariffs already imposed. Escalation to an all-out trade war will raise that tab to $2,200. Jobs will be hit hard, too, with upwards of 455,000 jobs put at risk.
- President Trump’s latest tariff increases on Chinese imports brought the annual cost of his tariffs to $831 per household, according to a study on the New York Federal Reserve’s blog
The whole premise of "trade wars are easy to win" depends on foreign countries bulging under U.S. pressure, while in fact, it's equally, if not more, likely it will achieve exactly the opposite and strengthen their resolve.
The tariff escalation on Chinese imports and the Huawei boycott has unleashed a wave of nationalism in the Chinese media. You don't have to have a degree in history to realize that bowing to foreign pressure is a bit of a sensitive issue over there.
Speaking about Huawei, there are a few things one might want to realize:
- While one could be worried about Huawei network gear being used for spying by the Chinese government, there is actually zero evidence this happened, or is happening.
- The arrest of the founder's daughter who is the CFO of Huawei in Canada on supposed breach of sanctions by Huawei becomes more curious if one realizes (as Jeffrey Sachs has pointed out) that the U.S. rarely arrests senior business people for alleged crimes of their companies.
On the latter, here is top economist Jeffrey Sachs:
"The US rarely arrests senior business people, US or foreign, for alleged crimes committed by their companies. Corporate managers are usually arrested for their alleged personal crimes (such as embezzlement, bribery, or violence) rather than their company’s alleged malfeasance. Yes, corporate managers should be held to account for their company’s malfeasance, up to and including criminal charges; but to start this practice with a leading Chinese businessperson, rather than the dozens of culpable US CEOs and CFOs, is a stunning provocation to the Chinese government, business community, and public.
Meng is charged with violating US sanctions on Iran. Yet consider her arrest in the context of the large number of companies, US and non-US, that have violated US sanctions against Iran and other countries. In 2011, for example, JP Morgan Chase paid $88.3 million in fines in 2011 for violating US sanctions against Cuba, Iran, and Sudan. Yet Jamie Dimon wasn’t grabbed off a plane and whisked into custody. And JP Morgan Chase was hardly alone in violating US sanctions."
Indeed, after the financial crisis, no single U.S. executive was arrested, despite many them walking away with hundreds of millions if not billions and plunging the world economy into an economy abyss.
The attack on Huawei is no accident but aimed at a company which has caught up, and in some ways overtook U.S. competition. That is, the whole 'trade war' notion with China contains another much more ambitious goal, which is to stop the technological advance of China.
This becomes clear when one considers President Trump's admission that he may resolve a dispute over Huawei as part of a trade agreement with China. This exposes the security risk argument as a hoax.
Huawei either constitutes a security risk, in which it is a completely separate issue from any trade dispute, or it isn't, in which case it is simply a bargaining chip to create leverage. It can't be both at the same time.
One is forced to assume this is the real goal, because the goal of reducing bilateral trade deficits doesn't make sense and would force one to assume those waging the trade war are economically illiterate.
Here is a (by no means complete) list of questionable arguments one comes across as rationalization for the tariffs on China:
- Trade isn't a zero sum game, the U.S. has also benefited from trade with China in the form of cheap Chinese imports (keeping inflation down) and Chinese investments in the U.S. (keeping interest rates down) and exports to China have also multiplied.
- U.S. companies have benefited enormously by locating parts of their supply networks to China and sourcing from China.
- Much of the huge U.S. bilateral trade deficit with China is a mirage, with much of the value added not actually being produced in China.
- Bilateral trade deficits are meaningless, reducing one will increase another one as long as the U.S. invests more than it saves.
- China has nearly eliminated its huge trade surplus (see below).
- Exports have markedly declined as a percentage of Chinese GDP (see below).
- Rather than manipulating its currency downwards, the last four years or so the PBoC (the People's Bank of China) tried to keep it up. If they let market forces rip (for instance abolishing the heavy capital controls), the yuan is much more likely to plunge, rather than shoot up.
- There are experts (see here and here) who argue that China's record on IP protection has been improving (which isn't that strange, given the fact that they are themselves a big source of IP).
Here is the Chinese trade surplus:
And here is the remarkable decline of Chinese exports relative to their economy:
The bilateral trade deficit the U.S. has with China is indeed very large, but apart from the fact that over half of the value added in electronics exports originates in other countries (among which the U.S. itself), the whole concept of a bilateral trade deficit as evidence of unfair trade practices is nonsense.
Yes, the U.S. can force China to buy more from the U.S. and open up their economy more to U.S. exports. If that would be their main demand, there would have been a trade deal already. But would that reduce the U.S. trade deficit? No.
What the U.S. would gain in trade with China, it would lose in bilateral trade with other countries, leaving the overall U.S. trade deficit grosso-modo unchanged. This is exactly what is happening, take for instance Vietnam. Here is the rising U.S. trade deficit with that country:
Basically, what is happening is that Vietnam is like China, only smaller and therefore less disturbing. It is attracting assembling and other fairly low value added activity on the back of low taxes, cheap labor and a low currency.
And this has been given a shot in the arm as U.S. companies are relocating parts of their Chinese supply chain to other countries as a result of the trade war. Vietnam is a main beneficiary of this shift. But, as Brad Stetser points out:
"Vietnam's exports to the U.S. are growing fast. It also runs an overall current account surplus. If it has resumed purchasing dollars in the foreign exchange market to keep its currency from appreciating, it may soon be a test case for Trump's policy toward countries that intervene to maintain an undervalued currency."
And of course putting pressure on China induces:
- China to retaliate, which is likely to affect U.S. exports to China.
- Reduces Chinese economic growth, which also affects Chinese demand for U.S. goods negatively.
- Leads to a yuan depreciation, which offsets part of the impact of the tariffs.
On the latter:
The yuan was strengthening earlier in the year on optimism on the trade front, but after Trump's May 5 tweet reigniting the trade war, that was reversed as the yuan fell nearly 5%. The fear is that it could fall a lot further.
So the trade war on China mostly shifts the problem of the large U.S. trade deficit and it sets in motion offsetting forces, it doesn't eliminate it. Any people armed with an economics 101 course could tell you this, so either policy makers have little economic knowledge or the goals are really different.
The grand decoupling
It is difficult to understand the U.S. moves in the trade conflict with China as just the desire to solve bilateral trade imbalances.
Resolving this bilateral trade deficit, no matter how futile, implies deeper economic integration, but the recent escalation and the Huawei boycott and some of the more onerous demands placed on China point to a more ambitious goal.
This ambition seems the desire to achieve something opposite to economic integration, a decoupling of the two economies and achieve the creation of a check on China's economic and technological development. Here is CNN (our emphasis):
"But a year into the trade war, there is a growing realization that Trump's tariff regime may become permanent. Over the past year, the White House has imposed tariffs on foreign steel and aluminum, on $50 billion in high-tech goods from China, on another $200 billion in commodities and manufacturing components from China, and has now begun the process of putting import taxes on everything else the US buys from there."
Indeed, Trump himself has delighted in the migration of suppliers out of China, weakening China's economy (too bad they're going to places like Vietnam recreating the same problem elsewhere).
We're not the only ones assuming the U.S. goals have more to do with the present economic superpower to cut the wings of the upcoming one, from VOX:
"Why would the US, the world’s largest and most significant economic power, choose to throw away a rules-based trading system that has served its interests for decades in favour of power-based bilateral bargaining with the world’s second largest economy? Aaditya Mattoo and Robert Staiger argue that long-term changes in the relative positions of the US and China in the world economy are the deep drivers behind the eruption of the US-China trade conflict. They frame the shift in US policy as the consequence of a decline in US hegemony over the global economy."
This poses an immediate risk for the world economy as SA contributor The Heisenberg argued:
"...remember that for the better part of a decade, China has been the engine of global growth and credit creation. That's a point that's been emphasized and reemphasized by analysts since 2015, when the yuan devaluation rattled markets and China concerns were top of mind."
The Chinese economy is already decelerating pretty markedly, further pain might induce policy makers to let the yuan fall further, beyond 7 to the dollar which has figured as a line in the sand before.
The Trump put
For most of the time, the stock market has taken the trade war in its stride, counting on the so-called Trump put, the belief that if markets went down too much, Trump would soften his stance.
After surprise May 5 tweet escalating the trade war with China, the Huawei blockade and the seemingly hard-line reaction from China, the Trump put is in serious danger.
How much remains of the Trump put after opening another front, with Mexico, really remains to be seen. We can't see much of it as it would take a pretty spectacular climb down for the Trump administration or, just as unlikely, significant caving of China and/or Mexico.
While surprises can't be excluded altogether, it seems that Trump has blocked himself in, and this is one of the reasons the markets have reacted with considerable ferocity with this being the worst May since 2010.
Since there is no easy solution with parties' stances hardening, the damage has time to accumulate. It is here where the immediate concerns lie, as this could develop into a self reinforcing loop of decelerating growth, declining markets and dulling sentiment and confidence.
The bond market has rallied very strongly, all the fears of an overheating economy setting off inflation have evaporated in record time.
Trump's job approval seems at record highs and his aggressive trade stance seems to be popular with a significant part of the electorate, so one could even surmise there is political calculation behind this.
But whether that will stand up if the markets plunge further and economic growth decelerates in a more serious fashion remains very much to be seen.
It's difficult to understand the U.S. trade moves with relation to China in terms of attempts at solving just a trade dispute.
As long as this was the claimed goal, solutions were available, but the fact that bilateral trade deficits are futile concepts, the more onerous demands made on China, the Huawei boycott and the recent escalation suggest the goals are much more ambitious and permanent.
We fear the real goals are, under the pretext of trade grievances, to create a check on China's economic and technological development. This is seriously misguided:
- Trade isn't a zero-sum game, China's development doesn't come at the cost of U.S. growth, in fact, quite the contrary.
- But the efforts to check China's economic and technological progress itself threaten to reduce U.S. economic performance. In fact, they're already doing just that and this could easily become serious.
- Now that the dispute has escalated and the real goals have become more clear, it's also more difficult for Trump to backtrack, deflating the Trump put.
- This might be reinforced inasmuch as Trump's aggressive stance renders him more political benefits than any market selloff complicates his re-election bid.
While we don't dispute that the U.S. (and others) have legitimate concerns, but this isn't the way to solve them. Opening a second front with another big trading partner, Mexico, is only going to compound the issues.
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.