The Trade War: What’s it Really All About?
The trade dispute between the U.S. and China is once again leading the headlines. The market had priced in that the trade war would remain conciliatory. It appears that trade negotiations have soured and the market has reacted appropriately with some downside moves and volatility spiking. Recently the U.S. has raised Tariffs, and China retaliated.
Why Economists don’t like Tariffs
Quite simply, tariffs move economies towards stagflation. This means slower GDP growth and higher inflation.
The table below from Ned Davis Research puts the above theory into reality.
Along with the above, NDR estimates that CPI inflation would increase .4 percentage points if there were 25% tariffs on all imported goods from China. This is meaningful given inflation is running around 2%.
Why Can’t Governments Just Agree? There is A LOT at Stake!
Over the last 30 years, China has grown significantly. For most of this time, China’s growth was driven largely by infrastructure investment. It still partially is. For example, creating a highway and rail system to transport people more efficiently increases productivity. Unfortunately, infrastructure investment has diminishing returns. The first dollar put to work in infrastructure has a much larger impact on growth than the last dollar put to work on infrastructure. Therefore, over the past 10-to-15 years it is no surprise that China’s growth has moderated.
Another way to grow is through technological advancement. Really, this comes down to human capital. For example, despite criticisms about “screen time,” the smartphone revolution has created massive efficiencies and has made us all more productive. It is true that China manufactures smartphones, but that doesn’t take any special skill or expertise that can’t be replicated by any other country or manufacturer. The skill or expertise, and thus most of the value created by smartphones, flows to the individuals that built the technology – the intellectual property (IP). The living standards of those that were part of the technological advance of the smartphone have improved far more than those that manufacture the smartphone.
This speaks to one of the core and most contentious issues of the trade dispute and likely one of the remaining negotiation items; China realizes that in order to continually grow, be a dominant force in the world for decades to come, and increase living standards (real GDP per capita) it must be a leader in technology.
Currently, the U.S. is far and away the leader in creating value through technological advancement. The complaint on China from many technological leaders around the globe outside of China is that China continues to steal intellectual property. This unfair business practice has allowed China to grow and become more dominant by the decade. The U.S. finally seems to be drawing a line in the sand over this issue and the parties have walked away from the table. At stake is not just technological dominance, but how powerful each country will be in the coming 20 plus years.
How It Could Play Out in Near Term
For most of 2018, the U.S. stock market and economy were advancing while the Chinese stock market was declining, and economic conditions were slow. Trump used this discrepancy to take a tough stance. He had the upper hand. When the U.S. stock market started a precipitous decline in Q4’18, Trump backed off his tough stance and became more conciliatory. President Xi in China followed suit. Both Presidents did NOT want to drive their economies or capital markets into a deeper correction. The U.S. Federal Reserve bank subsequently did the “Powell pivot” essentially saying they would not increase interest rates. The markets rallied in both the U.S. and China. With market strength, both sides may feel there is no rush to do a deal, and both sides may feel that they can take a tougher stance. Not too surprisingly, according to U.S. officials, the Chinese backed off some of their promises, and Trump threatened more tariffs.
Trump is up for re-election in about 1.5 years. As we get closer to the election, Trump loses some of his negotiating leverage. President Xi has no end date to his term. The Chinese know that Trump wants a strong market and economy to maximize his re-election hopes. Therefore, Trump will likely get more conciliatory if our market breaks down putting a limit on how far our market would go down on trade war news if all else stays the same. However, the major risk and unknown is will they act nice if Trump acts nice, or will they “twist the screws?” With no timetable on power, Xi can potentially be more patient. However, he must also balance achieving China’s growth target.
President Xi and President Trump are scheduled to meet at the G20 summit in June. Meanwhile, talks still seem to be ongoing in some fashion according to administration officials. The challenge of a deal likely rests on the Intellectual Property issue and this is a large, complex issue that the sides could continue to dig their heels in. At a minimum, the Trade War is likely to remain an overhang on markets for the foreseeable future. Volatility will likely remain elevated as market participants try to determine the effects on earnings of global businesses.
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