Monthly Markets Memo - May 2019
by Dan Zalipski, CFA
The Trade War Heats Up
Months of calm and optimism regarding the ongoing trade war with China were shattered with a single tweet from President Trump. U.S. officials claim China had reversed course on several key points of the agreement being negotiated between the two largest economies.
With this action the U.S. raised the existing tariffs on $200 billion of Chinese goods from 10% to 25%, a move that had been scheduled for March, and ultimately delayed as a sign of good faith due to the progress on the negotiations at that time. Trump threatened the Chinese not to retaliate, and things have only escalated from there.
China retaliated by increasing the tariffs to as much as 25% on $60 billion worth of U.S. goods. These goods include small aircraft, computers, chemicals, various agricultural products, and natural gas. Much of the goods that saw increase on both sides were already subject to tariffs which were simply increased. With China retaliating, the U.S. is expected to reveal a 25% tariff on all remaining imports from China, roughly $300 billion worth of goods.
The Chinese have floated the idea of selling its hoard of U.S. treasuries to gain the upper hand; China currently owns $1.13 trillion worth of treasuries. The idea being if the Chinese dumps their U.S. treasuries, a surge in interest rates will occur that will damage the U.S. economy. While the threat makes for a good headline, the practicality has such limited upside for the Chinese that the market has all but dismissed it as hearsay. As long as China remains a trading partner with the U.S., it will continue to hold U.S. treasuries as a way to manage the inflows of U.S. dollars buying Chinese goods, and to manage their own currency’s volatility in relation to the U.S. dollar. Furthermore, $1.13 trillion is a massive amount of money to move without a clear destination. The Chinese would need to determine where to put that money and the U.S. bond market is among the highest risk-adjusted yielding market in the world. The move would hurt the Chinese just as much, if not more, than the U.S. The threat has bark, but no bite.
Despite President Trump’s claim that China is paying the U.S. billions of dollars in tariffs, tariffs are actually paid for by businesses and consumers. Tariffs can result in higher uncertainty for businesses that can lead to slower growth in investments. Businesses may attempt to absorb the higher costs, but at some point, these will have to pass on to the consumer. Consumers, facing higher prices, will inevitably adjust their spending, potentially dragging down demand. With business either making less, or consumers spending less, there’s a concern of what the potential impacts could be to the U.S. economy.
The market reacted quite negatively to this latest development. The S&P 500 had its biggest one-day drop since January 3rd and is experiencing its worst start to the month of May since 1970. So far, the impact on the broader economy has been relatively small, but this latest salvo could be concerning. Should the U.S. follow through with 25% tariffs on all Chinese imports, and China retaliates in-kind, U.S. GDP could be reduced by 0.5% while China could see a reduction of 1.3%. The Chinese surely have more to lose than the U.S., but the U.S. has far less cushion in the forecasted GDP estimates to absorb escalating trade-war impacts.
At the time of this writing, no official trade talks have been scheduled, but the President is expected to speak with Chinese President Xi Jinping at the G-20 summit later in June. The two countries both want a deal, but neither wants to be taken advantage of. A compromise will likely be born out of some combination of economic, market, and political pain. The good news is there is an election coming up which will almost definitely serve as a motivating factor for a President looking to be reelected due to his work on the economy. The bad news is we have not hit peak pain, and the market will continue to be vulnerable to both the ongoing rhetoric and policy changes until then.
“Those who do us the great honor of investing in America, of doing business with our companies and suppliers, do so because we’ve always had predictable, reliable economic policies. Tariffs jeopardize that.”
Former Treasury Secretary Henry Paulson
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