Trade is the Word

By: Richard A. Anderson

For the past 18 months, two hot button issues for investors have been the Fed and trade negotiations between the U.S. and China. These two issues were the catalysts for two market corrections in 2018, the latter of which nearly approached bear market territory. However, for the first five months of this year fears of a Fed misstep were alleviated and reported positive progress towards a trade deal between the U.S. and China spurred markets to new all-time highs.

That is why many, including Chinese officials, were caught off-guard when President Trump tweeted on Sunday, May 5th, threats to increase existing tariffs and impose new tariffs on billions of dollars of Chinese imports. Some felt that these threats of additional tariffs were a negotiating tactic by the President, as these threats came on the eve of dozens of high-level Chinese officials arriving in Washington to hammer out the final details of a trade agreement.

On Friday, May 10th, the U.S. officially followed through on the President’s threats by increasing tariffs from 10% to 25% on $200 billion of imported Chinese goods. On Monday, May 13th, the Chinese government retaliated by imposing tariffs of up to 25% on $60 billion worth of U.S. goods starting in June.

The newest round of tit-for-tat tariffs between the U.S. and China has not been well-received by the markets. The markets have had a bit of a pullback in the aftermath of the renewed escalation of trade tensions, but an argument can be made this was the market looking for an excuse to take profits off the table. The tariff talk is the perfect excuse, and after rallying more than 25% since the December 26th lows, it shouldn’t come as a surprise to see a modest pullback. Markets have been extremely calm to start the year and this latest spike in volatility is normal. In fact, since 1949 the S&P 500 has averaged about 3 declines of 5% or more in every calendar year.

Taking a step back, tariffs and barriers to the free flow of goods and services are a big deal for myriad reasons. Tariffs impact global growth by slowing global trade, investment spending, and consumer spending.

As a reminder, a tariff is a “tax” on imported goods that is paid by the importing country, not the exporting country. So, when the U.S. places a tariff on Chinese goods, the tariff is paid by U.S. companies. The U.S. companies will, in turn, most likely pass much of its higher costs on to U.S. consumers in the form of higher prices. University of California at Davis economics professor Katheryn Russ estimates the latest round of tariffs will cost the average American household an extra $500 per year.

The trade negotiations between the U.S. and China have big ramifications for both countries. As the chart below shows, China is the U.S.’s largest trade partner. The chart also shows the U.S. imports more from China than it exports to China.

05202019_US Trade Partners.png

The reason the President and his administration have been negotiating a new trade deal is because of this significant imbalance between imports and exports. As the chart below shows, the U.S. has a growing trade deficit with China, which was $419.2 billion at the end of 2018.

05202019_US Trade with China.png

Up to this point, the impact of the retaliatory tariffs has not weighed as heavily on the U.S. as it has on China and other major exporters of manufactured goods. The U.S. has a smaller dependence on trade as a percentage of GDP and has been the beneficiary of massive fiscal stimulus from the Tax Cuts and Jobs Act of 2017. China, on the other hand, has a heavy reliance on trade and any slowdown in trade could significantly hinder its economic growth. Like most other countries, China’s access to the U.S. market matters more than the U.S.’s access to China’s market.

For this reason, it makes sense for both countries to reach a deal as quickly as possible. A trade war is a lose-lose situation. Of course, this is a sentiment that has been echoed since the first tariffs on solar panels and washing machines were levied by the U.S. back in January of last year.

But we can’t overlook the political aspect of these negotiations. With Presidential elections coming up, the President will want to make a statement with a victory in negotiations with China. Yet, Chinese officials will want to save face and show they won’t be pushed around. Both parties will want to avoid making unfavorable deals that could potentially harm the long-term growth prospects of their economies.

The latest bout of trade-related volatility serves as a reminder that the side effect of long-term gains is short-term declines. Global stocks will most likely continue to be sensitive to the trade negotiations between the U.S. and China. A quick agreement would benefit both countries, and the global economy as whole, but seems unlikely at this point. Therefore, it’s best for investors to buckle up because we are probably in for a bumpy ride. But this may be an opportunity to profit by staying invested while others who can’t handle the volatility head for the exits.