Market Recap

Posted on May 10, 2019 by Gemmer Asset

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Trump’s Tweets Torpedoes Trade


For the market the only news item of importance concerned trade and Trump’s tweets on the matter. Hopes for an imminent end to the trade war with China were dashed on Sunday night when the President threated to hike tariffs on $200bn of Chinese goods and begin proceedings to tax the remaining $325bn of imports not currently subject to tariffs.


Global equites sold off on the news and have now corrected roughly -2.5% from their highs. While it might feel like more, the losses have been pretty small. The chart below shows inter-year corrections, and while it doesn’t show an average, -10% to -15% doesn’t seem unreasonable.



We will touch on why the correction might have been modest, at least so far. But first let’s look at the new trade developments. Apparently over the weekend U.S. Trade Representative Robert Lightizer informed the President that the Chinese were backtracking on prior commitments to change laws dealing with issues such as market access, forced technology transfers, and intellectual property theft. When Trump made this public on Sunday the news surprised most everyone. The rhetoric of the last few weeks has generally been pointing towards a deal. Even after Sunday’s tweet the general consensus was this was just another negotiating ploy. But by Thursday it was clear the new tariffs would go into effect despite on-going meetings in Washington between the U.S. and China.


President Trump first imposed a punitive tariff of 25% on $50bn worth of Chinese industrial exports in July last year. That was followed in September by the imposition of a 10% tariff on a much broader range of goods worth about $200bn annually. These have now been increased to 25%. The administration is now working to impose the same 25% tariff on the all remaining Chinese imports, worth $325bn. If this was to go through, U.S. tariff levels would move well above those set by almost every major country out there, as you can see below.



Of course, this won’t happen in a vacuum. The U.S. sells about $2.3tn worth of goods and services overseas. Of this we sell roughly $120bn to China. Roughly 20% of this amount is made up of soybeans. Naturally our latest move to hike tariffs will lead to retaliation, and soybeans prices fell close to a 10-year low on Friday as traders anticipated the next step.



Another sign of the struggle farmers are having is the fact that unsold soybeans are already pilling up in storage even before this latest round of tariffs, as you can see below. China is moving much of their soybean purchases to other supplies.



Well aware of this, President Trump sent out a series of tweets on Friday that implied the U.S. would take the proceeds from the tariffs and “buy agricultural products from our Great Farmers, in larger amounts than China ever did.” He then said he’d turnaround and give the food away as food aid.


This latest tweet seems to imply another round of state subsidies for the U.S. farm sector ahead of next year’s election. By way of reminder, last year the administration put in place a $12bn aid package for farmers to prevent political backlash.


Gauging the Economic Impact


What are the economic consequences? Bank Credit Analysts laid out an interesting explanation of who wins and who loses when tariffs are applied. First take the case where we stop buying goods from China and simply buy the same product from South Korea.


“One might think that the decision to divert spending from Chinese goods to, say, Korean goods would be irrelevant for U.S. welfare. However, a simple thought experiment reveals that this is not the case. Suppose that a 10% tariff raises the price of an imported good from $100 to $110. If the consumer buys this good from China, the consumer will lose $10 while the U.S. government will gain $10, implying no loss in welfare. However, suppose the consumer buys the same good, tariff free, from Korea for $105. Then the consumer loses $5 while the government gets no additional revenue, implying a net loss in national welfare of $5.”


But of course, the goal of tariffs is to shift consumption patterns to domestic producers. Ignoring the fact that some of the goods China makes simply are not made in the U.S., surely moving our purchasing decisions to domestically produced goods is a win? Again BCA:


“Things get trickier when we consider the case where the consumer buys an identical domestically produced good for say, $107, in order to avoid the tariff. If the economy is suffering from high unemployment, the additional demand will boost GDP by $107. The consumer who bought the domestically-produced good will be worse off by $7, but wages and profits will rise by $107, leaving a net gain of $100 for the economy.


Today, however, the U.S. unemployment rate is at a 49-year low. To the extent that tariffs shift demand towards locally sourced goods, this is likely to require that workers and capital be diverted from other uses. When this occurs, there is no change in overall GDP. Within the context of the example above, all that would happen is that consumers would lose $7, reducing national welfare by the same amount.”


Now in terms of real-world numbers, The Economist had a good summary on Friday:


“With this escalation the cost from their trade brawl will soon become more visible. The new tariffs will shave as much as half a percentage point off China’s growth rate this year, according to most estimates. When tariffs were 10%, companies could generally digest the higher prices for Chinese imports, which were offset in part by a weaker yuan. At 25% they will struggle to do that, forcing them to pass more pain on to consumers. Inflation in America could increase by about half a percentage point as a result, according to economists at Société Générale, a French bank.”


Depending on how you model China’s retaliation, GDP growth in the U.S. could fall by 0.3% and 0.6% over the coming year, not a small number if underlying growth is just 1.5% or 1.75%.


Of course, these estimates do not factor in what would happen if the rest of China’s exports are hit with a 25% tariff. Interestingly, few consumer goods have been hit with tariffs so far. The chart below from Goldman shows that it has largely been capital and intermediate goods that have been taxed. If the administration takes the last step (tranche 4) then consumer goods would be hit hard and the impact on consumers far more apparent.



This means the prices for a whole range of consumer items would increase. Toys, shoes, clothes, electronics, etc. Not only will this change consumer spending, it will possibly have political consequences as well. Up until now only narrow sectors of the economy have felt the pain from ‘tit-for-tat’ tariff policy (farmers, Harley Davidson). If the situation escalates everyone will see an impact.


Odds of a Policy Put Increase


None of this is surprising. Economists typically don’t agree on much, but the impact of tariffs on trade and growth isn’t too controversial. Tariffs turn out to be a tax on the domestic economy and this is usually bad for growth and earnings unless there is a lot of spare capacity. So why didn’t the market get clipped by more on Friday, after all it started out down close to 2% in early trading? Two issues:


#1 – How Does China respond?


China isn’t in as bad a position as some make out. First, they are much less dependent on trade with the U.S. than they once were, as you can see below.



Furthermore, China also has plenty of tools to support their economy through fiscal and monetary stimulus. We are likely to see them pull these levers if talks deteriorate.


#2 – How will the Fed respond?


At the end of April most analysts were starting to downplay the odds of a Fed cut. After all, growth and unemployment trends were decent and financial assets were doing well. A trade war changes this dynamic. Stocks bounced on Friday after Atlanta Fed President Raphael Bostic said the central bank might have to cut interest rates if consumer spending suffers as a result of the new tariffs. Like it or not, the Fed put is back on the table.


How does all this play out? Of course, no one knows. Handicapping politics is nigh impossible. The Economist’s piece on Friday nicely captures the current situation:


“Most economists still think that the two countries will eventually reach a deal. As the downsides from tariffs become clearer, the reasons to strike an agreement, however tenuous, will prevail. But that is another way of saying that things may have to get worse before they get better. Exactly how much worse is the question.”


Have a good weekend.






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