While there has been no shortage of stories driving recent market volatility, trade war posturing has certainly been part of the equation. Last month, President Trump announced major tariffs on steel and aluminum. Considering the president’s lack of predictability, it may seem as if these tariffs came out of the blue, but in fact, they shouldn’t have been too surprising. He’s been a staunch opponent of NAFTA and has talked about trade imbalances for years, well before he ran for office. This protectionist rhetoric was key to his wins in the critical Rust Belt states of Pennsylvania, Wisconsin, Michigan, and Ohio.
Just months after taking office, Trump imposed tariffs on Canadian softwood lumber, followed in January 2018 by levies on solar panels and washing machines. Proposed tariffs on steel and aluminum in March upped the ante and were soon followed by $50+ billion in levies across more than a thousand Chinese imports. Not surprisingly, Beijing countered by proposing tariffs on US imports – targeting agricultural products from the Midwest.
Playing to the Base
This atmosphere of escalating trade tension has several political ramifications with potential market fallout. First, America’s trade policy has become more polarized, which creates uncertainty for capital markets. Investors had been reassured by the presence of Gary Cohn, a free trade proponent, as chief economic advisor to the president. However, Cohn resigned in the wake of the steel and aluminum tariffs. This departure left the protectionists on Trump’s team, including US Trade Representative Robert Lighthizer and trade policy advisor Peter Navarro, unchecked in setting policy. Economists and markets heaved a collective sigh of relief when Cohn was replaced by Larry Kudlow, a free-trade advocate. While Kudlow is known as a media sensation, he will most likely continue where Cohn left off, pushing back against protectionist policy.
This type of conflict is not unusual for the president. Trump makes decisions based on his instinct and relies on his advisors to worry about the details, so he likes to have differing opinions at the table and let his team haggle it out. In this instance, the president is trying to serve two masters: the free trade champions who have long been a pillar of the GOP base and the Rust Belt protectionists who got him elected. As he pinballs back and forth, markets will be caught in the middle.
Second, economists can argue over how much or how little the new tariffs will affect consumer prices and whether they will wipe out tax cut gains. However, increased tariff talk is a clear indication that Trump is thinking ahead to 2020 by making good on a campaign promise to his Rust Belt supporters. He essentially announced his re-election bid when he named Brad Parscale as his presidential campaign manager in February. The big question will be whether the perceived benefits to the steel and aluminum industries in the Midwest will politically outweigh potential pricing pressure on the very red agricultural states in his base. Only time will tell.
Third, these actions continue to show the world that the president’s “America First” agenda is for real. Like him or not, Trump’s order to investigate the Chinese theft of US intellectual property was a move that no president before had been willing to undertake. He has also indicated that he is more than willing to consider additional product tariffs if the Chinese continue to ignore intellectual property rights.
Gauging the Mid-Terms
As we approach the critical 2018 mid-term elections, presidential actions on tariffs and tax reform could make or break the GOP. The polls indicate that although a large portion of Americans don’t care for President Trump personally, many like what he is accomplishing in Washington and his willingness to champion American interests.
Are Trade Wars Easy to Win?
Unlike trade war politics, however, trade war economics are hardly in dispute and haven’t been for nearly 200 years. Trade isn’t a zero-sum game, so contrary to the president’s assertion that “trade wars are easy to win,” it might be more accurate to say that trade wars have no winners.* Thus the political rhetoric emanating from Washington – and rebounding from Beijing and other capitals – is a lose/lose proposition that has helped put the stock market on edge in recent weeks.
Looking Past the Bluster
Despite the recent trade-related market volatility, we think there are several reasons why investors should look past the trade bluster. First is the current broad and diversified strength of the global economy. In most regions, consumption is solid, government austerity is fading, and capital investment is beginning to rise. Moreover, global trade has been picking up steam after slowing in 2012-16.
The current environment is hardly analogous to the traditional cautionary tale of protectionism, the Smoot-Hawley tariffs. Enacted in 1930, these tariffs occurred after the US was already plunging into recession – and only made it worse. The overall strength of today’s global economy should help moderate the worst-case scenarios that markets fear.
Second, in the absence of any spillover effects (discussed below), the economic downside of trade skirmishes can be contained. To be sure, the trade volumes and dollar size of both NAFTA and US/China flows are significant and shouldn’t be taken lightly, but this cuts both ways. The very fact that trade flows are economically meaningful intensifies the pressure on US policymakers to minimize damage. We doubt the president is in any hurry to offset the positive economic impact of his tax cuts by throwing a trade tantrum. President Trump listens to the stock market as much as he listens to his base.
Third, investors should remember that so far, tough trade talk has been more rhetoric than actual policy. After just 15 months in office, a pattern is emerging from the Trump administration: hostile tweets and threats followed by more pragmatic negotiation and compromise. Yes, the rhetoric fires up the base, but half a loaf is better than none. For all his bombast on the subject, NAFTA is an intricate and complex multilateral agreement that can’t be altered by a tweetstorm. Likewise, the Chinese are ultimately pragmatists when it comes to trade flows. Most trading partners recognize that creating real trade policy requires a longer and more serious process.
Calculating Spillover Effects
So can we simply ignore the trade bluster? Maybe not. While we believe that trade talk by itself poses only a limited threat to markets and the global economy, there are potential spillover effects. A more comprehensive analysis of international relations would include not only the current account (imports and exports), but also the capital account (asset flows and foreign direct investment between countries), and the currency level that helps balance them.
Contrary to the assertion that the US maintains a chronic trade deficit with the world because of poorly negotiated trade deals, the real culprit is America’s consumption pattern. We consume more than we produce – and net imports (the trade deficit) make up the difference. This, however, is only one piece of a highly symbiotic relationship in which net exporters like China fund our deficits by recycling their reserves into US assets, such as Treasury bonds.
Any analysis limited to the trade component misses a larger point: This balancing act not only funds our excess consumption at reasonable interest rates but also limits yuan appreciation and supports China’s export-heavy economy. There will always be negative consequences for some (growing income inequality, dislocated workers, etc.), but on the whole, living standards are rising for countries open to trade and capital flows. For this reason, the real tail risk of a trade war comes not from higher prices or a restricted flow of goods, but from increased volatility in interest rates or exchange rates. The president’s recent comments about China (and Russia) manipulating their currencies is a good example of how trade issues can spill over into capital markets. For now, we believe markets will view tough trade talk as short-term noise because it’s in no one’s best interest to upset the delicate balance between trade, capital, foreign exchange levels, and interest rates.
* The basic model of free trade is that both countries are better off in aggregate. This model doesn’t guarantee that within a country workers in exposed industries won’t be disadvantaged.
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