The markets just don’t seem to care about the trade tariffs. Stock have been chopping around in a tight range, and the front end of the FF curve is pricing in roughly the same amount of hikes. The argument I hear all the time is that at the end of the day, a 25% tariff on $34B if imports is not going to have much of an effect on a $19 TRILLION economy like the US. I suppose that’s true. But you have to factor in that this dispute with China could escalate to $500B, and that we have similar disagreements with the EU, Canada, Mexico, and pretty much the rest of the world. Our total imports in 2014 was $2.2 trillion. And affecting one part of the supply chain could have a magnifying effect further down the line. The jury is still out in my mind.
I’m no trade expert. But the more I think about the situation, the more I think the central tariff scenario will be the following items, which could explain why the markets haven’t moved much:
- On Friday, the US imposed tariffs on $34B imports. If you are going to make a threat, you have to follow through.
- Soon thereafter, China followed through with retaliatory tariffs on $34B of tariffs. If you are going to make a threat, you have to follow through.
- The US will enact tariffs on an additional $16B of Chinese imports (to get to $50B total). The tariffs are currently in the hearing phase and could be enacted in two weeks. If you are going to make a threat, you have to follow through.
- The Chinese will retaliate. If you are going to make a threat, you have to follow through. What’s another $16B anyway?
- Trump will announce tariffs on $200+B of additional tariffs in retaliation for the retaliation…, as he promised. This may or may not be immediately announced (he can just announce it and say the details will be figured out). So chronologically this may be the first of the first three items to occur. This is going to have to wait two months to be enacted, which conveniently gets him to September (1.5 months to elections) without having to actually put any more tariffs. Trump haters and people in ivory towers will start soiling themselves.
- The Chinese will have to announce they will do something. Unfortunately, they only have about $100B in US imports they can tax. I’m not sure what the retaliation will be, but it should be something that cannot be one-upped by Trump. For example, it would be dumb to announce say 50% tariffs, because Trump will just laugh and say that we will retaliate by imposing 50% tariffs on 3x as many Chinese imports. It would have to be something difficult to counter.
- Around the time the additional $200B of tariffs get enacted (before or after), the two sides can reach a deal where both sides can save face. Why do I think both sides can come to terms? China has already offered some of the “basic” minimal concessions the US was looking for (majority ownership in joint ventures, easing of technology transfer requirements, additional purchases of US goods, etc). Trump is basically looking for gravy at this point. Trump has a midterm election to win. I suppose it’s possible his voter base could like his tough stance, but that 42% that approval rating is not enough to get his Congressional cronies elected. The bar to reach enough concessions for Trump to declare victory is fairly low.
- Ditto for deals with the EU, and some of the other US major trading partners. The EU auto makers have offered up a removal of the 10% tariffs on US cars (in exchange for a removal of the US’s 2.5% tariffs on cars and 25% on trucks). I’m speculating that potentially removing the 25% on trucks may be one of the reasons GM is backtracking on Trump. When you are in the business of making terrible vehicles, you weasel whatever and wherever you can. In any event, by making uncomfortable demands and being thought as a psychopath can sometimes be helpful. The squeaky wheel gets the grease.
He doesn’t have to get all the major trade deals done by elections. He just needs enough done to show potential. Add some additional corporate tax cuts, an infrastructure plan, reduced drug prices, some more progress on N Korea and he could look like a frigging genius (or just less of a moron).
I’m pretty sure that after items 1 & 2, the markets will do nothing. But if you are a Trump hater, you will think the world is crumbling before your eyes. The big question is, what will the markets do with item 3? If the markets don’t have a large reaction after items 3 & 4, I’m not sure it ever will. This is because it does seem like items 5 & 6 seem like fairly high probability scenarios. There isn’t that much time for any downturn to show up in our economic data, since the data usually lags a month or two, so Trump has a little room to gamble. The main place where trade tensions could show up is in equities, so I’ll be looking at that more carefully.
Of course there are tail risks.
- Upside risks to growth. Most of the chatter I hear of is that we are “late cycle.” But it seems to me that the cyclical theory of business is from the same backward-looking data-fitters that bought you such wonderful concepts like “six sigma” move (that is only a one sigma move), the Philips curve, the neutral rate, term structure models, etc. Of course, if the Fed is going to insist on hiking until any sign of the Inflation Boogeyman is dead, then I suppose there could be reasons for the cyclical theory (caused by the Fed). In any event, if we do get some “favorable” trade agreements, I see no reason why the current recovery couldn’t be sustained and be the start of another leg higher in growth. We do have a $700+B trade deficit with the rest of the world. Just reducing some of it could bring a surge of growth. The longer end of the curve in particular seems to be pricing in a more negative longer-term outlook. As a result, we could get a Trump-election type of longer end response at the end of the current trade friction.
- Downside risks to growth. This would include downside risks to equities. On the one hand, most people think equities are about 10-20% overvalued. But if we sold off that much, people would think it was the end of the world, and not a return to “fair” levels. In addition to equity pricing, we could have downside risk to economic growth. If “free” trade spurred global growth (albeit only 2%), then restricted trade should curb it, no?
We should consider the three Scenarios mentioned above: (1) the central scenario, (2) the upside economic scenario and (3) the downside economic scenario. This will be the topic of the Trade Thoughts section this week.