US and China trade tensions continue to escalate
Trade spat creeping toward full trade war
INSIGHT ARTICLE |
Over the past several weeks the probability that trade frictions between the United States and China could spill over into a full blown trade war has increased significantly. While we argue that this friction could still be viewed as the early innings of a trade spat (see: What does a trade war really look like?), the combination of macroeconomic and microeconomic distortions that help define when trade friction escalates into a full-blown trade war should be closely watched.
Diplomatic and economic interactions between the Trump administration and China are, for now, best described as “open mouth operations” that fall well short of an all-out trade war. Even so, the economic effects and price distortions for the middle market economy are potentially significant. If the trade interactions deteriorate further, we anticipate that larger businesses occupying the upper tier of the middle market economy (annual revenue of $50 million or more) will begin passing price increases downstream within their industry ecosystems. This would put at risk the expansion in revenues and profit margins that have been a hallmark of the real economy for most of the past 18 months.
The industrial ecosystems expected to be most negatively impacted by proposed tariffs and other possible retaliatory measures from China and other countries include agriculture, manufacturing, chemicals and energy.
Inside those ecosystems, the sectors that would be hit the hardest are civilian aircraft, electrical machinery, machinery, automotive and producers of soy, food oils and grain seeds.
Some 40 separate industry sectors within those larger ecosystems make up the target of Chinese tariff retaliation, putting 2.1 million jobs at risk.
Publically available employment data--specifically jobs in affected industries sorted by state—show that 12 of the top 15 states likely to suffer the greatest impact from retaliatory tariffs are those that supported President Trump in the 2016 election. These are also states that have largely been left behind in the asymmetric economic recovery following the 2008 Great Recession and subsequent transition to a new economy. Only three states—Washington, Oregon and California—will disproportionately benefit from the new economy, despite large exposure to Chinese tariffs.
Breaking down the potential negative impact of the proposed tariffs even further by U.S. counties, we find the potential tariff targets have been selected to maximize the impact across the agricultural and manufacturing complexes—in effect, the baseline political economy of President Trump’s electoral base.
To be clear, a trade war has not yet begun. However, forward-looking financial markets have extracted a price in areas such as soy, lean hogs (pork) and steel, which have seen price declines of about 7 percent, 29 percent and 8 percent, respectively. So far, the only noticeable price increase has been in U.S.-produced aluminum prices, which have risen just slightly more than 5 percent.
After President Trump’s February announcement of steel and aluminum tariffs and their implementation in March, the Trump administration on March 22 announced a so-called Section 301 action against China. The move included about 1,300 tariff lines, which can be found here and in the Harmonized Tariff Schedule of the United States.
The latest iteration of the trade spat involves the Trump administration’s threat to pose an additional $100 billion in tariffs on top of the approximately $50 billion across the 1,300 tariff lines announced last month. Given that China disproportionately imports only about $136 billion in goods from the United States, the potential retaliation could easily spill over into exports to the United States in areas such as the retail industry and the makers of consumer products. In fact, in the latest retaliatory salvo China just announced temporary anti-dumping duties on US sorghum exports of 178.6 percent. This will affect at least $957 million in exports to China.
Additionally, if the Chinese choose to retaliate in a proportionate manner, we suggest the trade spat could easily escalate to include non-tariff barriers; namely, increased paperwork, port quarantines, different environmental or consumer safety standards. Growing friction could also expand into limits on U.S. tourism and investment in China, and other financial limitations on U.S. activity with its largest trading partner.
While it has been suggested that the Chinese could conceivably either stop purchasing U.S. Treasuries or dump their roughly $1.2 trillion in U.S. debt holdings, we do not think that is likely, at least for now. The Chinese need to purchase U.S. Treasuries in heavy volume to manage their awkward currency regime. If China attempted to dump its U.S. government securities in heavy volume, the Federal Reserve would simply step in and purchase those securities to prevent a jump in interest rates and a depreciation of the U.S. dollar.
Beyond equity markets, which have posted declines largely linked to U.S.-China trade tensions in four of the past six weeks, one poorly understood risk is linked to the nature of foreign direct investment by the middle market and large businesses over the past quarter century. Tariff regimes are direct threats to regional and global supply and value chains. They tend to cause businesses and economies to move away from specialization and comparative advantages. Thus, as businesses have to move to pay higher prices and not benefit from sunk costs in assets abroad, microeconomic distortions mount and macroeconomic costs increase. This is particularly true for middle market businesses with supply chain exposure to China and other Asian countries as they often have less supply chain flexibility than their larger competitors.