Last week took investors on a roller coaster ride. The climax came at the stroke of midnight on Friday, May 10, when U.S. President Donald Trump’s newest tariffs went into effect – a 25% toll on $200 billion of Chinese goods. Then later on Friday, the negotiations ended with no material progress, and there are no formal plans to resume talks. What’s more, China retaliated the morning of May 13 by announcing tariffs on U.S. goods being imported to China.
As regular readers of this blog may recall, I have always been quite pessimistic on the possibility of the U.S. achieving a meaningful trade agreement with China. I have worried about the negative impact of tariffs and the potential that China can retaliate against the U.S. in a meaningful way. In addition, I have always believed there is a misguided concern by the U.S. over trade deficits. Free trade has historically produced lower prices by enabling companies and consumers to purchase from the lowest-cost provider – cheaper imports from China have lowered U.S. consumer price levels by 1% to 1.5% in aggregate.1 That is meaningful for lower- and middle-income Americans. For a typical U.S. household earning about $56,500 in 2015, trade with China saved families up to $850 that year.1 Conversely, the imposition of tariffs and other forms of protectionism will only serve to drive up prices, in my view. Tariffs can create inflation – not by stimulating demand, but by simply increasing the cost of goods.
When a new tariff is imposed, one of three things could happen:
- In some industries, companies will be unable to pass the cost onto its customers. This means the company’s profits would be reduced. For public companies, this would negatively impact earnings and could therefore impact stock prices.
- A company passes the cost of tariffs to their customers (as, for example, Apple has suggested it would do) and consumers pay more for the same item. This means that, all else being equal, they have less money left to spend on other goods or services.
- A company tries to pass the cost of tariffs to their customers, but there is demand destruction as consumers cut back their purchases. Traditionally economists have largely discussed demand destruction in the context of energy. For example, if the Organization of the Petroleum Exporting Countries (OPEC) lowers production, thereby increasing oil prices, consumers may reduce their driving and thereby their consumption of oil, creating demand destruction. In the case of the current trade wars, we have already begun seeing demand destruction in an industry that was one of the first to experience the imposition of tariffs at the start of 2018: washing machines. The same fate could befall other items, including other “big ticket” purchases such as autos, if tariffs are applied to them.
The problem with tariffs as a revenue source
I am becoming increasingly convinced that a trade deal may be a long way off – for several reasons.
First of all, China has made it clear it has serious reservations with the U.S.’ demands regarding intellectual property and technology transfers, which are critical terms for the U.S. And, as I have said before, China believes it can “wait out” the Trump administration. As was reported in the May 13 Wall Street Journal, one senior Chinese official explained that “Time is on our side.”
In addition, I am beginning to worry that the U.S. may begin to rely on tariffs in order to help counter the growing U.S. budget deficit. We recently learned that the U.S. budget deficit increased dramatically in the first seven months of the fiscal year (October 2018 through April 2019) to $531 billion, up from the $385 billion deficit it ran during the same period a year earlier.2 Federal outlays rose 8% to nearly $2.6 trillion, although some of this was due to the timing of benefit payments, while revenues increased 2% to $2.04 trillion.2 It is worth noting that tariff collections nearly doubled from October through April, to $39.9 billion from $21.8 billion, which certainly helped with the revenue increase.2
The idea that the U.S. may need to rely on tariffs to help increase revenues in a difficult budgetary environment seems to be supported by some recent presidential tweets:
- “Tariffs will bring in FAR MORE wealth to our country than even a phenomenal deal of the traditional kind. Also, much easier & quicker to do. Our Farmers will do better, faster, and starving nations can now be helped. Waivers on some products will be granted, or go to new source!”3
- “Talks with China continue in a very congenial manner – there is absolutely no need to rush – as Tariffs are NOW being paid to the United States by China of 25% on 250 Billion Dollars worth of goods & products. These massive payments go directly to the Treasury of the U.S….”3
However, the problem with tariffs is that 1) they don’t get paid by China – they get paid by Americans; and 2) they are not progressive like income tax. That means they disproportionately affect those Americans in lower- and middle-income brackets because those taxes represent a larger portion of their incomes. (Income taxes are based on a percentage of a person’s income; tariffs cost the same no matter how much a person earns). And so, while thus far the U.S. consumer has shown significant strength – which is not surprising given how strong the U.S. labor market is – we will want to follow consumer confidence and spending closely as the tariff wars heat up.
The impact of economic policy uncertainty on business investment
I believe a greater concern is business investment. Building on years of findings, economists Huseyin Gulen and Mihai Ion concluded that economic policy uncertainty has a strong negative correlation to business investment.4 It has also been demonstrated that positive shocks to the Economic Policy Uncertainty Index have been accompanied by significant decreases for at least two to three years in several data points – in particular, industrial production, employment, GDP (gross domestic product) and real investment.5
Trade policy uncertainty is a particularly potent form of economic policy uncertainty. In the past year, anecdotal information from the Federal Reserve (Fed) Beige Book and purchasing manager surveys have indicated that some companies are curtailing or suspending business investment plans, citing trade policy uncertainty. Given this recent deterioration in U.S.-China trade relations, we will need to follow business investment plans closely as well.
More volatility ahead?
Looking ahead, we should expect continued volatility in both equities and fixed income. My base case is a resumption in negotiations, episodic flare ups in tensions, markets moved by both positive and negative news flow, and no meaningful deal reached any time soon. In the near term, I wouldn’t be surprised to see a continued flight to safety favouring U.S. Treasuries and yen, and stocks selling off – although at a certain point I expect bargain hunting to begin. Investors may or may not be comforted to know that, in my view, this sell-off could be a lot worse if the Fed hadn’t changed its policy stance this year.