This is an excerpt from our most recent Economic Outlook report. To access the full PDF, please click here.
Ongoing trade negotiations do not seem to show any signs of a silver lining at the horizon.
Rather we appear to move from one level of escalation to the next. As of late, we see indications that more and more countries are becoming ensnared. Tariffs seem to have become the U.S. President’s preferred tool of foreign policy, given the recent proposed tariff escalation against Mexico as a way to handle Central American immigration concerns. For the longest time, pundits have avoided the use of the words trade war and preferred euphemisms (e.g. "trade skirmish").
Given recent developments, one might wonder -- how concerned should investors be? Will all of this ultimately be just noise?
First of all, it’s helpful to recall: trade negotiations –- even contentious ones -- are not unusual. In 1995, the World Trade Organization was founded as a primary institution to settle trade disputes. Since then, the U.S. has been involved in roughly 2 per month either as complainant or respondent. Given the size of the U.S. market, it is not that surprising that most disputes involve the U.S. This implies none of the current negotiations (except for the threat of tariffs towards Mexico) are unusual. But rather, we are witnessing them out in the public, due to the confrontational approach taken by the current U.S. administration.
That being said, what are the scenarios that could unfold in any future negotiations between the U.S. and China? Like so many other observers, we see the G20 summit at the end of June as the prime opportunity for the two parties to re-start negotiations:
- Trade agreements are concluded successfully: While reaching a trade agreement might appear to be the best-case scenario (and equity and fixed income markets will surely show a positive response to this) we want to caution our readers. When it comes to trade agreements, we cannot judge a book by its cover. The history of trade agreements has shown again and again. Immediately after trade agreements are reached, negotiation partners tend to show ‘buyer’s remorse’ and begin reversing some of the negotiations immediately. That is, while concessions are made to allow access to certain markets by lowering tariffs, we often find that non-tariff barriers (NTBs) to trade are used as a tool to thwart agreements. They come in all sort of flavors such import quotas, subsidies, custom delays, technical barriers, or any other system that prevents trade (e.g. all shoes sold in Country A need to be approved by a regulatory agency focused on customer safety). One of the reasons for the popularity of NTBs is they are relatively opaque to outsiders and difficult to regulate (unlike tariffs which are openly increased/decreased). Interest groups can influence these without government support.
- Trade agreements are not concluded and put on ice: While this scenario is on the opposite end of the spectrum -- and most likely causes further volatility in equity and fixed income markets -- we do not think it will be as bad as it will appear initially. For similar reasons we outlined in section (a). Importing/exporting firms have become very creative over the years when it comes to alleviating the effects of tariffs. One of the most obvious ways is adapting supply chains, since none of the tariffs are imposed on companies but rather on products. That is, if products are produced domestically, then tariffs could be avoided (easier for larger companies that have more intra-company flexibility across subsidiaries), or they simply conduct some final touches in the target country. Another approach is to disguise the origin of products, by shipping them indirectly towards the destination country, or classify the product slightly differently.
- Kicking the can down the road: The third scenario is in our view the most likely one. That is a further stalling of trade negotiations. We most likely see a continuation of a Game of Chicken. Both sides will employ different PR tactics, trying to improve their political position in any future negotiations. In our view, this will be positively impacting the markets (through rising rate cut probabilities) as long as we don’t see further credible threats of more tariffs. That is, bad news can be considered good news by the markets. Watch tariffing, not words.
The U.S. Presidential election due in November 2020 delivers a critical political asymmetry. The 1-party state Chinese government is managing public information available internally. China’s leaders can endure, even enjoy, slower growth. Nationalism is on the rise among the Chinese. U.S. actions dovetail with a long history of formal attacks and open trade exploitation by foreign sovereigns over 2 centuries. Conversely, the U.S. administration wants to have a big trade win in hand with China -- before they go to the polls.