Trade disputes have been an overhang on markets for much of the past two years, but lately have taken the lion’s share of headline space following the deterioration of the US-China trade negotiations. President Donald Trump began discussing the possibility of using tariffs whilst still on the campaign trail, and began making good on those promises in early 2018 when he raised tariffs on a collection of Chinese products, followed by tariffs on steel and aluminum from most of the world. Since then, the US has introduced new tariffs on over 800 categories of Chinese goods with a total value of $200 billion, and has threatened increasing the scope of tariffs to include the full $530 billion in goods that the US imports from China annually. While the trade dispute with China continued to intensify, the US administration broadened the scope of aggressive trade policies to include Mexico, threatening to use tariffs to affect change in the country’s immigration policies. In most cases, US tariffs have been met with retaliatory tariffs on US exports, an escalation of trade tensions, and increasing stock market volatility.
Tariffs are a tax designed to make foreign imports more expensive, with the hope that it will cause demand to shift in favor of domestically produced goods. The United States has had a trade deficit (importing more goods than they export) each year for over 40 consecutive years. When a trade deficit exists, the difference between imports and exports must be funded with foreign investment, which frequently takes the form of US debt. This borrowing has contributed its fair share to the US government’s massive debt load, which currently stands at about $22 trillion. In theory, but rarely in practice, policies that give an advantage to domestic industry against foreign competition should help to reduce that trade imbalance. Beyond affecting the balance of trade, the current policies also have an element of negative reinforcement, punishing countries until they curtail certain policies that disadvantage the US including intellectual property theft, and now even immigration. There is still a debate, however, about who actually pays for the cost of tariffs.
In the short run, US businesses who rely on inputs from China are unlikely to have the supply chain flexibility to switch to domestically produced substitutes and will be stuck paying for more expensive imports. With higher input costs, US businesses would either have to accept lower profits, or raise their prices to offset the increased costs, effectively passing the bill to the US consumer. In the longer run, it is possible that China would have to slash prices on exports to US customers to remain competitive with untaxed domestic goods, and the effects of tariffs would be seen in lower Chinese profits. Most economists would probably argue that the cost is spread across the entire supply chain from exporter, to importer, all the way to the end consumer. Regardless of who foots the bill, all scenarios result in governments taking a piece of the pie, and leaving less for the businesses of the world.
The decline in both US and Chinese stocks around tariff announcements implies that investors are of the opinion that there are no winners in a trade war. There is no question that China does not “play fair” in terms of technology transfer and appropriation of intellectual property. If the aggressive policies by the US result in improvements in these areas, then we may be able to call it a “win” of sorts, but the longer the squabbles continue, the higher the costs are likely to be.
While we believe a prompt resolution and freer trade would be in everybody’s best interest, we don’t think that these disputes are a reason to panic. The US economy is strong: unemployment is near a generational low, inflation is subdued, and the Federal Reserve has begun signaling a shift towards more supportive monetary policy. Furthermore, although the tax on $530 billion of goods sounds like a large amount, it is not so large compared to the US GDP of $20.5 trillion in 2018. Finally, despite the aggressive political posturing, we are confident that both sides would like to minimize the negative impact that an extended trade war would surely cause. At the end of 2018 the S&P 500 retreated 19.8%; just 0.2% short of the threshold that indicates a bear market. At that point, it seemed that all involved had suffered enough losses and were ready to make small concessions in the interest of making a deal. One takeaway from that experience is that stock market turmoil seems to make both leaders more agreeable. Unfortunately, that may mean that things have to get worse before they get better. Let’s hope it doesn’t come to that.