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Tariffs and US-China trade

| May 17, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

US-China trade looks likely to continue to be a key market theme for the foreseeable future. The short-term impact on the US economy could be noticeable but is probably manageable. A deal still looks likely this year, though it may take several months to reach a final agreement. The ability of global companies to move their supply chains means that the US is likely to gain leverage as time goes by, which will likely force Chinese negotiators to accept the deal that was reportedly almost complete before talks broke down earlier this month.

Recent developments

No US-China trade agreement looks imminent, and President Trump, while open to a deal, seems happy to impose tariffs.  The US has hiked tariffs on $200 billion of goods from 10% to 25%, though this increase does not apply to shipments that left China before May 10, which means, practically, that it will take effect on goods arriving in the US beginning around June 1. China countered with tariffs on US goods worth about $60 billion a year, also with an effective date of June 1.  This gives the two sides a little time to cool off after the breakdown in the talks, but the US also intends to continue pressing its case. The US has drawn up another list of Chinese goods though no final decision to go forward has been made, and it would take at least a month to go through the proper procedures to put new tariffs in place. The administration also intensified its campaign to keep Huawei and ZTE from participating in the buildup of 5G networks in the US due to concerns that the companies’ equipment could be used as a back door for the Chinese government to spy on people in the US and globally.

Composition of imports from China

 The US imported $540 billion worth of merchandise from China in 2018.  While there are a number of high-profile consumer goods categories that are heavily imported from China, such as cell phones, apparel, shoes, and furniture, plenty of imports from China to the US are intermediate goods—goods used in the production of other goods and services.  In fact, the two largest categories of imports from China in recent years are electrical machinery and equipment—although almost half of the imports in this category represents cell phones—and machinery and mechanical appliances.  In fact, those two categories represents close to half of all US imports from China.  Other significant types of imports that are not usually sold directly to consumers are medical equipment, chemicals, and auto parts.

There are a number of consumer goods for which imports from China are critical.  The US imports more than $30 billion a year in furniture, more than $25 billion in toys, games, and sporting goods and more than $30 billion in apparel and footwear.  In the case of furniture, toys and sporting goods, and shoes, over half of all US imports of those products come from China and domestic production in each of those categories has dwindled to a small part of total sales, so that it is fair to say that China is the dominant supplier.

Tariff selection and inflation

When the US initially imposed tariffs on the $200 billion tranche of goods last year, officials carefully selected the list of items that would subject to the added taxes in an effort to minimize the direct impact on US consumers.  High-profile consumer goods such as smartphones were quite purposefully left off of the list.  As a result, the 10% tariffs on these goods that have been in place since last year have raised costs for many US businesses but have not had a noticeable impact on consumer prices.  While it has been noted that prices for certain consumer goods subject to tariffs have risen significantly since the imposition of tariffs last year, the combined weights of the items in question in the CPI do not add up to a large enough weight in aggregate to move the needle for headline or core inflation.

The imposition of tariffs, by itself, does not tell us whether and by how much consumer prices will be impacted.  That depends, on a case-by-case basis, on whether the firms in question have sufficient pricing power to pass their higher costs through to their customers or are forced to absorb them.  In large part, it is reasonable to think that tariffs of only 10% can be absorbed in most cases, but 25% duties are likely to create much more pressure to pass along rising costs.

In theory, some combination of four things can happen when tariffs or a tariff hike are implemented.  For an example of a consumer good, the options are: 1) costs are passed along to the consumer, 2) the retailer pays a higher price for the good, fully reflecting the cost of the tariff but absorbs the hike without raising the price to the consumer, 3) the retailer forces the supplier to absorb the costs, or 4) the retailer avoids the tariffs by switching to a supplier in a different country.  President Trump seems to think that China will absorb the cost and effectively pay the tariffs  Failing that, he suggests that stores should switch suppliers, preferably finding a domestic producer, though that may not be practical, especially in the short term, for many of the consumer products in question.

In reality, in most cases, the answer will be more nuanced.  In fact, tariffs would presumably be passed through 100% to consumers in very few cases.  I suspect that, typically, consumers, retailers, and suppliers would all share in the hit.

In any case, the Administration is also considered slapping tariffs on another $300 billion of imports from China, which would cover pretty much everything that has been exempted so far.  That final big round of tariffs would likely have a much more substantial impact on consumer prices, since it would be hitting mostly consumer goods and would also be hitting many goods for which China is the dominant supplier limiting the ability of firms in the short term to substitute alternatives from other sources.

Consumer spending is more than $14 trillion, so a few hundred billion worth of goods sounds like a lot but really is not as significant as one might think from a macroeconomic standpoint.  In the extreme case in which tariff hikes all hit consumer goods and are passed along entirely to the retail price, the move from 10% to 25% tariffs on $200 billion worth of goods would add about 0.2 percentage points to headline inflation.  The proposed additional round of tariffs on another $300 billion, if it was a 25% duty, could add another half a percent.  In reality, the actual impact on inflation is likely to be less than half of that.  More importantly, a tariff hike will be viewed by the Fed and presumably most consumers as a one-off increase in the level of prices rather than a persistent acceleration in the rate of inflation.  Thus, the Fed would probably not put much weight on the upward pressure on prices since it would be a transitory factor.

Growth Effects

Calculating the growth impact of tariffs is even more problematic than examining the effect on prices.  Going back to our menu from above, presumably in cases where the retailer or supplier absorbs the tariff, there is no direct impact on real economic growth, just a cut to profits for either a US retailer or a foreign producer or some of both.  If tariffs are passed through to prices, then the key question is how sensitive demand is to prices.  If a cheap pair of sneakers goes from $20 to $25, does the quantity sold go down by 5%?  10%?  25%?  100%?  At the other extreme, if consumers just pay the extra cost, they are out a few bucks in disposable income.  Do they have to cut spending elsewhere?  Save less?

Again, starting with the arithmetic, 15% of $200 billion—going from 10% tariffs to 25%–is $30 billion, while a new round of 25% tariffs on another $300 billion worth of goods is $75 billion.  We could be talking close to $100 billion worth of tariffs imposed, which would undoubtedly delight President Trump, but that is not necessarily a game-changer relative to $14 trillion in consumer spending and over $21 trillion of nominal GDP.  At the extreme, that $100 billion would be about half a percentage point of GDP, but realistically, the direct impact would likely be lower, as foreign suppliers would take some of the hit and households might respond in a number of different ways.

From a growth perspective, the bigger concern would be the second- and third-order effects.  Uncertainty surrounding the outlook for trade policy could lead businesses to postpone major investment projects, which may not have a huge permanent impact on growth, but could slow it in the near term to a significant degree.  More broadly, if business and consumer confidence in the US takes a major hit due to fears of a trade war, spending could pull back.  Alternatively, a sustained deterioration in financial markets, along the lines of what we saw on the initial Monday following the breakdown of talks, could have a substantial negative impact on economic prospects.  These are the dynamics that represent a threat to the outlook over the next few quarters, and they are quite difficult to quantify or handicap.

Prospects for a deal

In broad strokes, the traditional relationship between the US and China has been that China’s inexpensive labor provided a low-cost option for sourcing relatively simple products on a massive scale.  China has tried to work its way up the value-added scale and get involved in more complex, high-tech areas but up to now has had limited success.  The Made in China 2025 campaign rolled out in 2015 was a systematic blueprint laid out by China’s leadership for dominating key industries of the future, displacing the US and others.

After China ramped up efforts to grab market share in advanced industries, the Trump Administration emerged with a different, more combative stance toward trade with China.  Trade hawks see the Made in China 2025 initiative as an effort to take US technology and, combined with inexpensive labor and state subsidies, gain a dominant position in key industries.  The US negotiating team is determined to prevent that scenario from playing out.

It is interesting that the politics in the US around trade policy toward China have evolved dramatically over the last two years.  When President Trump first began to propose tariffs against China, there was near universal howling that protectionism was a bad strategy and that he was courting economic disaster.  Now, while economists and market participants continue to be concerned about the near-term impact of a possible trade war, there is broad agreement that the US needs to take a more combative stance toward China, in particular regarding intellectual property.  Thus, the Administration appears to have a more solid political position domestically in the talks than might have been expected.

Whether a deal gets done is anyone’s guess, but an agreement at some point this year still looks likely, though it is more likely to be several months from now than a few weeks away.  The strong prospects for a deal reflect the likelihood that China could be be a disastrous loser in the absence of an agreement.

President Trump has one important thing right that many commentators in the US have gotten woefully wrong.  A trade dispute will hurt China far more than it will hurt the US. The US is a net buyer of goods, and we can always source our supply chains elsewhere, albeit perhaps at a higher cost.  In fact, the most important thing that is happening over the past few months is that companies are moving supply chains out of China to less expensive or tariff-prone locales or in a few cases, back to the US.  In the latest example, Stanley Black and Decker announced that it is building a plant in Texas to make Craftsman wrenches, bringing production home from China, a development that would undoubtedly have been considered improbable until recently.  The rapid shift of supply chains out of China is amazing.  If China allows the tariff spat to continue for another six months, its production dominance in a number of industries may be challenged in ways that could be disastrous for the Chinese economy.

In contrast, the US economy is well-positioned to absorb a little damage for a time.  Economic growth has been quite strong and inflation is arguably, if anything, too low.  Of course, things could theoretically get out of hand quickly and the Trump Administration will be hoping to present a strong economy in 2020 as a key reason to re-elect President Trump, but the Administration appears to be playing the sort of long game that China is said to be so good at, risking a little short-term pain to get to a solution that can be a major positive in the long run.

There were clearly miscalculations on both sides that led to the recent breakdown, and one was that Chinese negotiators reportedly assumed that the US was desperate for a quick deal.  The hardliners on the US side may actually believe that time is on their side given how nimble global companies seem to be with their supply chains.

Of course, there is also the serious question of whether China could be expected to abide by whatever agreement the US manages to hash out with them.  Based on the experience of the last 20 years, there is good reason for skepticism, which is why President Trump or Trade Representative Lighthizer should drive a hard bargain but not hold out for a perfect one.  Any agreement will need robust enforcement provisions.  For market participants, an announcement of an agreement would be a massive relief, but will likely not be the end of this issue once and for all.

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