What to Watch for as Both Nations Seek the Optimal Outcome for Themselves
By J. Richard Fredericks, Main Management
The trade war with China has now intensified. Late last week, China reneged on some of the terms on the deal. They might have believed that Trump was desperate to do a deal, but instead their action resulted in Trump ratcheting up the pressure by upping the tariffs to the maximum extent possible. In our mind, the Chinese made a major gaffe as they badly miscalculated the Trump position. Some comments on the current state of play follow.
- On Friday, Trump said that he would raise tariffs on $200 billion of Chinese products. Mr. Trump, who last week threatened to slap tariffs on more than $300 billion of other Chinese products, said on Monday that he hasn’t made a decision about whether to proceed with that additional action.
- China responded that they “will have to take necessary countermeasures” and said tariffs will increase to 10%, 20% or 25% for most of the 5,140 U.S. products on which it currently imposes levies of 5% or 10%. Additionally, they have submitted formal complaints with the WTO.
- A quick resolution seems unlikely. It is hard to see where the ‘off-ramps’ are for either side as both sides ‘lose face’ if they back away from their hardened positions.
- Pride is a factor on both sides. President Xi, through his negotiator Liu He, wanted all the extra tariffs imposed by the US to cease and desist, and that any deal “must be balanced and preserve Chinese dignity”. Despite how friendly Trump says he is with President Xi, when he tweets out that “I think that China felt that they were being beaten so badly in the recent negotiation that they may as well wait around for the next election” is not a way to save the dignity of China. Both leaders believe that they must stand up to the other in order to make them look strong with their constituencies back home.
- The Chinese, no doubt, have been watching our stock market and may have thought that Trump needs the market to remain strong to be reelected, so they could have been emboldened to walk back some of the terms of what was being negotiated. In our view, that was not smart. The timing of their retaliation response underscores this point as they announced their intentions just before the market opened, which was the middle of the night in China.
- Thankfully, there is some time built in for some re-negotiation. There is a three-week transition period and exclusion process that has been finalized. Goods in transit have been exempted which means that goods that have been shipped before May 10th would not be subjected to a 25% duty as long as they arrive in the US before June 1. Timing aside, we do believe that talks will continue at the Ministerial level, although the rhetoric suggests that the parties are further at odds with each other than before this past weekend.
- President Trump believes he is in the driver’s seat as the USA GDP is growing at a robust level in contrast to a slowdown in China; our unemployment rate is at a 50-year low; and despite the recent drawdown, the stock market is still up significantly over the past 2+ years. Further, given the disparity of what is imported to the USA ($539.5 Billion in 2018) versus what is exported to China ($419.2 Billion in 2018), the action will definitely hurt China more – especially with the higher rate of tariffs (Source: Census Bureau).
- President Trump doesn’t seem to like to roll back tariffs. In fact, he has frequently said publicly that he likes tariffs and that “tariffs make our country much stronger, not weaker” and he revels in all the billions flowing into our Treasury. We believe it makes the negotiations that much tougher given Trump’s attraction to the revenues generated from tariffs. That said, if he were to impose sanctions on the remaining $300 billion of imports, it would more than double the revenues from the tariffs, so if he likes the tariff tally now, he surely would like double that amount later. As further proof that Trump doesn’t like to roll back tariffs, all one has to do is look at the USMCA deal with Canada and Mexico, which is currently in limbo, because of the President’s current unwillingness to remove steel and aluminum tariffs.
- Personally, we totally disagree with the Administration’s trade logic as trade benefits everyone and it is not a zero-sum game. Gains from trade are “positive sum” while tariffs subtract from economic growth. Trade is a “voluntary exchange” where both sides feel they are better off in the process. It is no different than dealing with one’s own cleaners or gas station who never buy anything from us. There is no need for a “balance” between the participants. That is true whether the transaction takes place locally, across state lines, across the country, or even between countries around the world. Why is that? Nations don’t trade, people trade amongst themselves because they believe they are better off in the process. Adam Smith argued in “The Wealth of Nations” that it was superfluous and counter-productive for any government to attempt to manage and direct the importing or exporting of goods and services to maintain a presumed ‘favorable’ balance of trade. Each individual tries to minimize the costs that must be incurred in achieving his goals and ends. He or she only would make at home what is less expensive to make than buy from others. When governments, through regulations and controls, force a product to be produced at home that could be less expensively purchased from abroad, it is misdirecting scarce resources and labor into wasteful and inefficient uses. The result must be that the wealth of that nation – and the material wellbeing of its citizens is reduced. Meanwhile, the other side of the trade, by definition, is a capital surplus as the cleaners now have our money but we get our shirts back. Many observers forget that side of the equation. The only justification for Trump’s trade war is to stop China from stealing our intellectual property. If he achieves that, the exercise is worthwhile.
- Is there a second derivative aspect to the Trump strategy? Could he be thinking that as he presses the Chinese, it will force them to stimulate which would help their economy, help the world economy, and ultimately help our own economy in the process? We wouldn’t be surprised by that logic as it would have the impact of furthering both our economy and stock market and thereby increasing his chances of re-election. Consequently, President Trump might not be in any kind of hurry. As mentioned, the economy is in good shape, so the closer to the 2020 election that the trade dispute is resolved, the better his chances may be for re-election.
What we believe should be monitored in this spat –
- From a political standpoint, Congress, at least so far, is backing a firm stance on the China negotiations with Senators from both sides of the aisle giving President Trump their commitment to combat intellectual property theft. It remains to be seen, however, how many of the Senators running for President will continue their support as the impact on our own economy becomes more apparent. Will they vacillate in their support?
- While the cost of the action is minor at only a potential reduction of 0.15% to 0.50% of GDP, according to some estimates, the key question will be the corporate reaction. Will they hit the pause button on planned capex programs and other investments? At this juncture a global company has to be in a confused state as to where they should invest; where they should produce their incremental product volumes; and where they hire people or even whether they should hire more people.
- Confidence measures – both business and consumer indicators – should be monitored. Probably the best measure to watch is the monthly release of the Chief Executive Office index on confidence. While that survey comes out monthly, another timely indicator to watch would be the weekly unemployment claims which can also be considered a confidence indicator as it reflects the willingness of companies to hire more employees.
- The China economy itself needs to be monitored. We have been encouraged that with all the stimulative moves that have been initiated, China’s economy has begun to show signs of strength. That would suggest that there will hopefully be a lesser knock-on impact with emerging market economies, but in that regard, the Yuan/Dollar relationship needs to be closely monitored as a weak Yuan would lead to a strong dollar, which in turn, would hurt the emerging market countries. Hopefully, China will not choose to fight the tariff battle only on a currency basis as it could be destructive to world growth.
- There has been some discussion that the Chinese might sell some of their position in US Treasuries. While that can’t be ruled out, it would likely hurt the value of their own investment portfolio.
- President Trump often cites the stock market as validation of his economic policies so if our market begins to significantly underperform China’s (or vice versa), it could be a tipping point in the negotiations.
- Whatever the direction of the negotiations, one can never underestimate the power of a Trump tweet which could change the results one way or the other at a moment’s notice.
We believe a trade deal will ultimately get done, but it will take more time than we, or the market, had previously believed. As we mentioned above, we suspect the Ministerial level of conversations will continue, but they will no doubt reflect President Trump’s and President Xi’s views and directives. There are two possible chances for the principals to meet and have direct conversations to move the ball forward. President Trump will meet from May 25 to May 28 in Japan with Prime Minister Abe and the new Emperor, so a face-to-face meeting with President Xi could be tacked on to that meeting. We suspect, however, that is too early a time frame to expect any concrete results. The second chance will come in June 28-29 with the G-20 Summit in Osaka, Japan. Both Presidents are expected to attend. Interestingly, efforts to reform the World Trade Organization are on the proposed schedule. We originally expected a deal could have been announced then, but now perhaps the best expectation is that a meeting at that time could finalize a deal (40% probability) or more likely, put the deal back on track (60% probability). Stay tuned!
J. Richard Fredericks is founding partner at Main Management, a participant in the ETF Strategist Channel.