TRADE WARS
By Mark Ukrainskyj in Trusted Advice
With US tariffs on steel and aluminum already in effect, tariffs on $34 billion of Chinese made goods scheduled to start on July 6th and threats of more tariffs affecting almost $800 billion in total of imported goods, it is no wonder that the business media and markets are worrying more about the possibility of a trade war. While many commentators say these threats are simply negotiating tactics intended to bring our trading partners to the table, the specter of the Smoot-Hawley Tariffs and their crushing effect on global trade during the Great Depression tends to drive these worries.
As a general rule, economists agree that free trade is better overall for an economy than protectionism, so market nervousness is understandable. Tariffs on imported goods are eventually passed through to consumers, either wholly or in part, thus increasing costs for domestic consumers. This then slows economic growth. That is the theory.
In practice, free trade agreements are rarely truly 'free trade' with no barriers whatsoever to either side's goods or services. While many barriers and tariffs are reduced, each side inevitably seeks more protection for certain groups. The European Union has a 10% tariff on imported cars versus the US's 2%. The US has a 25% tariff on imported pickup trucks. Fellow NAFTA member, Canada has a 270% tariff on imported milk. Then there are non-tariff barriers, such as standards and certifications, not to mention China's mandates for domestic joint venture partners and technology transfer, which most of the developed world agrees need to be reformed or eliminated. And technology transfer entered the discussions this weekend. One could go on and on.
This is not to say that the overall US and global economy as measured by GDP have not benefited from free trade agreements. They have. Just that they are the result of human negotiations based on the situation at the time and that while the overall situation is better, some groups win and some lose. And over time, the situation can change. The China that joined the World Trade Organization at the end of 2001 was a very different country than the China of today. Then its GDP was $1.3 trillion and it had a trade surplus with the US of approximately $83 billion. In 2017, Chinese GDP was almost $13 trillion and the trade surplus with the US was over $375 billion.
Context is also key in discussing the situation. While the $800 billion of imported goods under threat of possible tariffs is certainly a large number, it represents approximately 4% of the US's $20 trillion in GDP. And tariffs between 10% and 25% on those would then equal 0.4 to 1.0% of GDP. In comparison, most economists expect US GDP to grow at least 3% for the rest of the year, due at least in part to the tax reform enacted at the end of last year. So should all of the so far announced, or threatened tariffs be enacted (baring a full scale termination of trade agreements such as NAFTA), the worst case scenario would be to bring US growth down to 2 to 2.6% or higher. Normally a slowdown in growth is not welcome and there is never a good time for a trade war. However, with unemployment at 3.8%, more jobs posted than people looking for work, and US GDP growing at over 3%, this appears to be a less bad time than most.
For most of the year, investors have rewarded growth oriented investments and punished more defensive and yield oriented ones. However, as the rhetoric has ratcheted up on both sides over the last couple of weeks, investors have begun to seek out more defensive investments. After underperforming most of the year, the Utility and Consumer Staples sectors have moved up recently. In turn Industrial and Materials stocks seen as vulnerable to trade tensions have retreated sharply. Technology stocks with long term secular growth stories had been relatively unscathed, until the last few trading sessions, as investors began to raise cash from profitable trades in highly liquid stocks. While such profit taking may have a temporary effect on the stock prices of these long term growers, over time their superior positioning and growth potential should keep their stock prices moving up.