Trade wars: Bull in a China shop

I really like my title this week because it works on so many levels! On one level the bull is President Trump of course. And the China Shop is the Chinese economy which Trump is attempting to restructure, to what he thinks will be the US’ advantage. The ‘bull’ is also, let’s call it the male cow ‘fertiliser’, that Trump is talking due to the depths of his misunderstanding of economics. And the whole phrase captures the damage Trump is doing both by his trade policy itself and the chaotic way he is going about it.

In this post I will look at the risk Trump’s trade policy poses for the US economic upswing. Next week I will explain why Trump’s trade policy, even if he gets what he wants, will boost China’s economy more than the US.

The US stock market fell by more than 3% on Tuesday while the 10 year yield continued its sharp decline, having lost more than 30bps since early November. Markets are seemingly unnerved both by worries that the agreement in Argentina will only postpone a full-blown trade war and concern that Trump is approaching the whole negotiation in a chaotic way. Trump’s claims for what was agreed at the meeting with Xi Jinping were not confirmed by China while other members of the US administration seemed to equivocate over what China actually agreed to. It didn’t help when Trump tweeted ‘I am a Tariff Man’.

Still, is all this enough to kill the US upswing? In its latest World Economic Outlook the IMF published estimates for the impact of the trade war, based on different scenarios. The direct damage to the US economy of the tariffs announced so far (including the increase in tariffs on some goods from China from 10% to 25% which is now postponed to April 1st) is a modest 0.2% of GDP. But there is also a threat of expanding the tariffs to 25% on almost all Chinese and other countries’ imports including on cars and car parts. The IMF naturally assumes retaliation by other countries. Then the hit jumps to about 0.7% of GDP.

The IMF further adds in the potential impact of lower confidence on US investment and tighter financial conditions (due to a lower stock market in fear of the outlook) and the total loss of GDP due to the trade war could be 1% of GDP. For reference the full impact of the trade war on China could hurt by as much as 1.5% of GDP, while for Japan the figure is 0.7% and the euro area 0.4%. Note that the IMF is using a global model for this, so all the feedback effects between countries are taken into account.

These are just estimates of course, requiring some fairly heroic assumptions. But as far as I can tell, the IMF is not crying wolf. If anything this could be an under-estimate because they don’t take enough account of the risk of a break in confidence. Especially since it is not just about a trade war. The US government, at all levels, has shifted to a markedly more hostile stance towards China over the last year. So the risk of measures beyond tariffs, such as sanctions or a military confrontation, have increased from negligible a few years ago to at least 10-20% over the next few years. Any sign of something concrete developing could bring a sharp decline in confidence and a freeze in investment.

Most forecasts see the US economy slowing to the 2-2.5% range in 2019 as the effects of the fiscal stimulus peter out and Fed tightening takes its toll. Subtract another 1% from that number, in line with the IMF scenario and growth might be only 1%. A number that low could even see a technical recession in the form of 2 quarters of negative growth although it is unlikely the NBER would call it a recession. But if the IMF have under-estimated the effects of a confidence hit, or if the US and China challenge each other in other ways, a recession is certaintly a possibility.

As I have argued in previous blogs the US economy only fairly recently (2016) entered the Late Upswing stage of the cycle, so the usual vulnerabilities that build up in this stage are still not that intense – for example over-leverage or market bubbles. Moreover, the wage response still looks muted which is allowing the Fed to move cautiously. This is all good news because it lowers the risk of the trade war triggering a recession, AND the risk that any recession is severe.

There are other reasons for being sanguine. The IMF figures are based on the US pursuing its trade war with Europe and other countries as well as China. This seems less likely than it did a few months ago.

Most importantly we can assume President Trump will try to avoid a bad outcome. If he wants to run again in 2020, a recession starting in late 2019 or 2020 would severely damage his chances. Hence the market has been assuming all year that a deal would be done. Trump the ‘great negotiator’ is assumed to have a grand plan to force some concessions out of China, declare victory, then dial all the confrontation down. But the chaos in the administration after the Argentina meeting puts that in doubt. My guess is that the market reaction Tuesday was as much because of fears of the US government blundering into a bad outcome than anything else. But there are still plenty of reasons for thinking it will see sense and pull back from the brink.