Trade War: Entering a New Phase?

8 June 2019

President Trump’s recent decision to hike tariffs on an additional $200 billion of Chinese exports escalated the trade war. The US administration has suggested they will consider levies on a further $300 billion of US imports from its Asian partner following the June G20 meeting. It remains unclear if the imposition of these charges is a simply a negotiating tactic aimed at coercing concessions from China. Or, does President Trump consider tariffs to be a permanent way to “level the playing field” in bilateral trade relations. As I have argued elsewhere, there is no quick fix to the Sino-US trade imbalance. Thus, it would appear likely that these tariffs will remain in place for awhile, and further hikes seem probable.

If this were not bad enough, America’s recent threat to impose similar charges on Mexican imports takes the tradewar into a considerably more dangerous phase. Weaponising tariffs to pursue wider policy aims (immigration in this case) is arbitrary and unpredictable, and would certainly damage business confidence even more significantly than the measures against China. No doubt President Trump believes these tactics will appeal to his political base. Fortunately (and predictably), the US Republican leadership, who are focused on the economic consequences prior to the 2020 elections, appear to have persuaded the President to abandon this strategy, at least for now.

I still expect common sense and mutual interests to prevail eventually. If I am wrong, however, the risks to the global economy will intensify. To be sure, financial markets have been rattled by the escalating trade war, but the possibility of a 2020 recession certainly has not yet been priced into valuations.

Tariffs: Diverting & Damaging Trade, But No Solution

The objective of US trade policy, one would think, would be two fold. Firstly, to create new export opportunities (and the jobs that go with them) for US businesses. And, to contain the overall trade deficit to a level that prevents an excessive dependence upon foreign capital inflows. What’s happened during the past 2 1/2 years? Not only has the Trump Administration’s trade program failed to curb the external shorfall, the deficit balloned from $735 to $875 billion between 2016 and 2018. And I project it will rise further this year. After expanding at a healthy 7% clip during the past two years, US exports have stagnated in 2019. The recent poor US export performance largely reflects retaliatory measures by foreign governments (China especially) to US tariff hikes: exports to China have declined 20% so far this year (after falling 8% last year). So, the trade war is now taking its toll on American businesses.

However the most important reason for the continued deterioration in America’s external position has been its insatiable appetite for foreign goods: imports have risen 8% annually since 2016. In 2019, however, US imports have also stagnated. The Chart above illustrates a predictable effect of tariffs. To be sure, American purchases of Chinese goods have decline 13% this year. However, US spending has simply been diverted elsewhere. Imports have surged from other Asian nations, especially Vietnam, and purchases from Mexico and Europe remain robust.

Important shifts in response to tariff hikes also have occurred in China. To be sure, the Chart above illustrates that imports from the USA are down 30%, especially for soybean and other agricultural products. However, China has been able to source these products elsewhere: note surging imports from Brazil, Canada, and Australia. On the other hand, Chinese exports have stagnated this year, led by the sharp decline in sales to the USA. But, China has succeeded in improving its performance in Canada and European markets. As we will observe later, the trade war has adversely impacted Asian supply chains, to the detriment of all.

These outcomes are predictable, as the US external deficit reflects the nation’s low savings rate (Chart above). And, the rising US budget deficit will lower US thrift furhter in coming years. As a result, the US trade shortfall is likely to widen further in coming years, despite the Trump Adminstration’s aggressive bilateral trade approach (Chart below).

Weaponising Tariffs: Global Risks Spread, Deepen

The prospects of a trade war has been taking its toll on global manufacturing activity for well over a year — note the broad-based, worldwide slump in PMI surveys (Chart below). Few readings remain above 50 — the recession threshold.

The following Chart provides helps identify countries in which US trade access is not reciprocated, e.g. where the US export/import ratio is below the level for all trading partners. It is easy to understand why China has been the primary focus. On the other hand, Canada, Mexico, and the European Union are not particularly problematic. As a result, I was confident the NAFTA/USMCA issues would be quickly resolved, and the likelihood of a transatlantic trade dispute is low.

However, the weaponisation of tariffs to pursue broader political aims is especially worrisome for many reasons. First, the policy is arbitrary and unpredictable, and will have an even larger impact on business confidence. The focus now is Mexico and immigration. Later it could be Europe, given President Trump’s distain for the EU and NATO. Why not India or Brazil…the list is potentially endless. Evidently, not even important allies are immune from these capricious measures. Also, in the case of Mexico, the policy threatens the successful passage and implementation of USMCA. Moreover, the importance of Mexico to the US economy should not be underestimated: the US exports more than twice as much to its southern neighbour as it does even to China. In addition, if higher tariffs derail AMLO’s reforms and destabilise Mexico’s economy, the immigration problem could get worse.

The Chart above illustrates that Mexico’s economy is already fragile, especially manufacturing activity and business investment (which declined 2% in Q1 2019). Exports, on the other hand, remain a bright spot: rising 6% this year. Tariff hikes could choke off a key source of Mexico’s recovery.

In addition, it’s not just the countries in the tariff firing line that take a hit. The Chart above illustrates Brazilian weakness, as President Bolsonaro takes over, e.g GDP contracted during Q1 2019. Again, exports are benefiting from new opportunities in China (next Chart), but capital spending has declined sharply during the past two quarters. Of particular concern has been the slump in exports throughout Asia. This suggests that the trade war is disrupting the region’s key supply chains, a worrisome signal for capital spending and technology world-wide.

The Fed to the Rescue?

Slowing US economic activity and slumping equity markets has led investors to believe that the US Federal Reserve will lower interest rates up to 75bp during the next year. Will the Fed come to the rescue? Recent inflation trends would appear to give them scope to do so. The following Chart illustrates that core inflation pressures have eased in recent months. The same is true in other G4 nations, which will allow central banks to maintain ultra-loose policies in the coming period (and perhaps easing further at some stage).

The Federal Reserve justified its policy U-turn in early 2019 — aborting its well established pattern of hiking interest rates — by pointing to a sharp tightening in financial market conditions (e.g. wider corporate credit spreads and sharply lower equity markets). The following Chart (provided by Morgan Stanley) illustrates financial conditions have tighened again, but not to the same extent as before the previous policy pivot.

Therefore, while I do expect the Fed to lower interest rates, the pace may be slower than the market now anticipates. The first cut should come in September. An additional reduction prior to the end of 2019 would result from a combination of additional tariffs on China, the introduction of levies on Mexico, and a further slowdown in US economic activity.

Strategic Implications
  • I anticipate additional US tariff hikes on China products in coming months. On the other hand, I expect Republican leaders to prevent President Trump from weaponising tariffs on Mexico and other partners prior to the 2020 election.
  • The Fed will lower rates twice in the next 12 months.
  • If I am wrong and tariffs reach 25% in both China and Mexico, the US economy will slide into recession during the 2020 election cycle. Together these two partners represent nearly 30% of US trade.
  • Heightened US policy and economic uncertainty justifies a lower equity market P/E ratio. Slowing (perhaps declining) S&P500 EPS growth and contracting valuation multiples will cap the relief gained from easier US monetary conditions. I believe this combination supports our view that the S&P 500 will remain in our 2,600 to 3,000 range this year (year end target remains 2,800). Market valuations are not pricing in the possibility of recession at present: the recession target would be 2,250.
  • The Chart above illustrates that US equities have again become very cheap relative to bonds. At some point, therefore, stocks will regain momentum. This will require a bottoming in economic activity and greater clarity on trade policy — a combination which may not emerge until after the next year’s election (more on that as events unfold).
  • Heightening trade tensions have weakened the case for EM equities, although I favour Europe over the USA. The following Chart illustrates that several EM currencies, including the Mexican peso, are very undervalued. If tensions ease, opportunities would exist at some stage.