Key Points
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Markets erupted in a “tariffs tantrum” last week with the Trump administration’s ramped up protectionism aimed at China.
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Tariffs have not historically been successful at erasing trade deficits or stemming the secular decline of industries; and have come at a cost.
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The stock market can probably handle ongoing trade spats; but if actual trade war risks begin to rise, we would likely see more tantrums.
Last week the United States Trade Representative (USTR) announced the Trump administration’s decision on trade measures against China under Section 301 of the Trade Act of 1974. They incorporated punitive 25% tariffs on up to $60 billion of annual imports, and included the aerospace, information/communication technology, and machinery sectors; with possible future additions including medical equipment, rail, maritime, BioPharma, and industrial robotics. The full list of tariff rates is expected within 15 days, followed by a 30-day comment period from U.S. stakeholders; the USTR will also bring a World Trade Organization (WTO) dispute settlement case on China’s technology licensing practices.
The reaction (so far) from China was swift—but somewhat benign relative to worst-case assumptions. They put forth a preliminary list targeting 128 U.S. products, accounting for about $3 billion of U.S. imports; including a 15% tariff on steel pipes, fresh fruit and wine, and a 25% tariff on pork and recycled aluminum. But it’s expected China may levy tariffs on more U.S. products such as consumer electronics, aircrafts, agriculture (e.g., soybeans), capital goods, and software/services.
As noted by Eurasia Group: “Overall, the approach announced…is far from maximalist (i.e., doing it all at once). Instead, the administration’s approach appears to be a rolling process to balance multiple goals: avoiding a major impact on global markets, consulting a wide range of stakeholders, and ultimately allowing room for a negotiated solution.”
Trade deficit swamped by China
As you can see in the chart below, the goods trade deficit between the United States and China is the largest by far. [For those who were paying attention to the controversy President Trump initiated with his comment that the United States has a deficit with Canada—if services were included, the deficit shown below would be a surplus.]
U.S. Goods Trade Balance by Country
Source: U.S. Census Bureau, as of January 31, 2018.
President Trump and USTR Robert Lighthizer have talked a lot about tariff “reciprocity,” with a goal of making it more difficult for Chinese companies to operate in the United States. This view has fairly strong bipartisan support—certainly more than around NAFTA-related trade. While many in Congress have been expressing concerns about various aspects of the administration’s protectionism, none have actually defended China’s trade practices.
Opening salvo?
The proposed tariffs against China is just the latest salvo in an ongoing trade “spat,” which began with the Trump administration’s levying of tariffs on steel and aluminum product imports, a proximate cause of the latest bout of market volatility/weakness. Related to that, the ongoing turmoil and personnel turnover within the Trump administration added fuel to the trade fire; in particular given the more hawkish leanings of National Security Advisor designate John Bolton and Secretary of State designate Mike Pompeo.
The two charts below show the top-10 largest U.S. imports from China (top) and the top-10 largest U.S. exports to China (bottom).
Imports to/Exports From China
Source: U.S. Census Bureau, as of December 31, 2017.
Widening the lens
The total volume of world trade has nearly quadrupled since the early 1990s and is at a record high. This means the global economy is more interconnected than ever before; while nearly every country has been a beneficiary in one form or another. Speaking of interconnectedness, many products made in China are actually made by non-Chinese companies—many of which are U.S. companies—and are links in a longer and more complicated global supply chain. For instance, Apple’s iPhone is “officially” made in China, but it includes components from Japan, Taiwan, Korea and the United States. Even relatively moderate trade barriers would likely disrupt these complex chains.
Few would argue against the notion that China has been waging a stealth war with the United States on trade for many years. Indeed, China’s admission in 2001 to the WTO has had more adverse implications than what was assumed at that time. Trump’s election victory was partly a result of legions of Americans who have felt disenfranchised due to globalization; with declining real incomes and lessening employment opportunities. Although manufacturing has been in a secular decline for decades, China’s ascendency to the WTO undoubtedly exacerbated the decline.
President Trump and many of his key advisors on trade—including Lighthizer, Director of Trade and Industrial Policy Peter Navarro, and Commerce Secretary Wilbur Ross—are staunch believers in protectionism. They are revolting against what has been a long-held view by much of Washington that global free trade is a means for global stability.
But will tariffs work?
Any country’s trade balance is a function of many factors, including the value of its currency and its standing as a destination for global investment. Overly-simplistic trade balance analysis ignores many of the realities of today’s global economy. The United States’ relationship with its trade balance is relatively unique because of its position in the global economy: the U.S. dollar is the world’s reserve currency and the U.S. capital markets attract more foreign investors than any other nation.
There is no question that U.S. tariffs are low in comparison to other countries—aided by past administrations which accepted this discount in order to promote global stability. But it’s unlikely that protectionism will turn around the U.S. trade deficit, or reverse the degeneration of U.S. manufacturing. The U.S. steel and aluminum industries have been in a secular decline for many decades and prior attempts at stemming this via tariffs failed. Past administrations attempted import restrictions at various times in the 1970s, 1980s; and most recently in the early-2000s; with arguably more negative than positive results.
The most recent experiment occurred in 2002 when President Bush imposed tariffs of 8-30% on a variety of steel products. Indeed, it did cause a waning in steel imports for a while, but at a significant cost to the economy. A study that year, titled The Unintended Consequences of U.S. Steel Import Tariffs: A Quantification of the Impact During 2002 by Dr. Joseph Francois and Laura M. Baughman, found that many U.S. companies which relied on steel imports were small and had limited pricing power, which resulted in significant layoffs—to the tune of about 200k. Clearly, that was not the intended outcome. The tariffs were abandoned in late-2003.
There is also the simple math associated with the steel and aluminum tariffs: there are about 400k workers employed by those two industries; while there are more than six million workers employed by companies and industries that use these metals as inputs. This is known by economists as “negative effective protection”—industries not protected by tariffs are often damaged by them. In addition, this year’s fiscal stimulus is likely operating in direct conflict with the desire to narrow the trade deficit, given that any increase in consumer spending will be apportioned to a greater degree toward lower-price imports, as is typically the case.
Stock market’s message to protectionists
Although we of course don’t know whether we’ve seen a market inflection point, today’s significant strength (as of this writing) likely reflects a calming of nerves amid news that there are quiet negotiations occurring between the U.S. and Chinese governments. President Trump has a proven record of storming out of the gates before ultimately slowing to a trot. Perhaps the “tariffs tantrum” which erupted last week in U.S. and global stock markets sent a message to a President who has been known to tie the stock market to his initiatives.
We are believers in the benefits of global trade. It encourages competition by allowing countries to engage in their own competitive advantages, which in turn makes the global economy more efficient and keeps inflation from running amok. A trade spat turning into a trade war could wreak havoc on global supply chains and have negative implications for growth, inflation, productivity and real incomes.
The endgame
The economic ties between the United States and China are powerful and disrupting them in a condensed period of time will likely have ripple effects into our economy and on the consumer in particular. Neither consensus economic nor earnings growth forecasts have yet been broadly adjusted—perhaps due to the perception that the temperature has dropped a bit on trade. But flare-ups which elevate the risk that the trade spat turns into a trade war remain a possible volatility-driver for the markets.
Eurasia Group put it well when they wrote: “The administration’s strategic plan both signals and instigates change, leaving the endgame as the only uncertain element…Successful negotiations to preclude escalation and thwart tangible impact on consumers are the signposts to watch—there will be volatility along the way, but the president and his party cannot afford an open-ended trade war.”
Important Disclosures
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