An all out trade war between the US and China would be calamitous for global trade.
Chances are that most investors are not familiar with Reed Smoot or Willis Hawley. But you may soon be hearing a great deal more about this pair of obscure US lawmakers who sponsored the US Tariff Act of 1930. Almost 90 years after their legislation triggered a global trade war widely blamed for plunging the world economy into the Great Depression, president Donald Trump’s US administration stands accused of posing a similar threat, much to the chagrin of financial markets.
In fairness, the president is doing nothing more than fulfilling his pre-election promise to implement an ‘America first’ trade policy. Just as Messrs Smoot and Hawley wanted to protect US businesses, notably farmers, from cheap imports, so Trump thinks China’s economic practices are unfairly damaging key US industries. Chinese sales to the US of $500 billion (£367 billion) a year dwarf the $130 billion of US exports heading in the opposite direction, he points out.
The president’s plan to level the playing field is to impose a series of tariffs on goods imported into the US, targeted at areas where those goods are particularly likely to come from China. His first foray was to unveil tariffs of 25 per cent and 15 per cent respectively on steel and aluminium imports. This was followed by proposals to extend tariffs to high-tech goods such as robotics, aerospace and biopharma, where Chinese sales to the US total $100 billion a year. And Trump is now threatening to up the ante, by using laws normally reserved for use against rogue regimes and terrorist groups to curb Chinese investment in the US.
Some analysts believe the president won’t go that far. ‘The US administration’s plan would seem to be to achieve concessions from China in opening up its markets to US goods and services,’ argues Keith Wade, chief economist at fund manager Schroders. ‘The aim would be to have a victory ahead of the mid-term elections [in November this year] so that the president can claim that his robust approach to trade has been vindicated.’
Nevertheless, global markets have taken this outbreak of hostilities very badly. Trump’s initial policy announcements in March sent equities worldwide into a spin – in the US the S&P 500 index fell by more than 7 per cent over the month – while bond yields spiked. Since then, each new twist and turn in the tariffs row has prompted another bout of volatility.
Trade war talk
What investors fear most of all is a full-blown trade war. Naturally, China isn’t taking the US’s hostile acts lying down: it has responded with tariffs of its own on US goods and promises more to come if Trump follows through on his threats. China also has a secret weapon up its sleeves. It is one of the world’s biggest holders of US Treasury bonds, and it could start selling these holdings, which would force up US bond yields and raise the cost of US government borrowing. This would have the unfortunate side-effect of whacking investors in supposedly super-safe treasuries.
More broadly, China and the US aren’t the only protagonists in this conflict. Many of their tariffs on imported goods will also hit other countries hard, prompting them to retaliate. Not least, the EU has already threatened to introduce tariffs on billions of dollars of US goods – think consumer staples such as jeans and peanut butter.
Such an escalation would be ‘mutually assured economic destruction’, warns John Wyn-Evans, head of investment strategy at fund manager Investec. ‘Greater trade friction reduces overall global growth and tends to create more inflationary pressures, owing to the tariffs imposed and less choice for consumers,’ he says. ‘This is quite the opposite of what we have experienced for much of the past half-century, a period that has been generally kind to investors.’
Given what’s at stake, you might think the president sees an upside for US businesses that is big enough to justify the risks about which he is now being warned. So do tariffs work? Not really, according to most economists. They may provide a short-term boost to a given industry you seek to protect, but the damage they are likely to cause to an economy as a whole will outweigh the benefits.
The trouble with tariffs
That was the case when tariffs of 30 per cent were imposed by president George W Bush’s administration on steel imports to the US in 2002. The obvious beneficiaries were US steel companies, as the imported steel undercutting them became more expensive. As a result, sales of US steel in the US increased. However, other US businesses, including some customers of US steel producers, lost out, because they had to pay more for steel. Suddenly, the cost of manufacturing everything from food cans to motor vehicles spiked sharply upwards. Those higher costs were passed on to consumers, either in the form of higher prices or in less generous wage settlements from the companies affected, which suffered a dip in profitability. Consumers, in turn, had less spending power, which had a negative effect on other businesses. This dismal spiral continued for almost two years until Bush finally withdrew the tariffs in the face of a legal threat from the World Trade Organisation.
The net effect of this negative feedback loop, according to one study, was the loss of 200,000 US jobs. To put that figure into context, the US steel industry, which Bush hoped to protect, employed just 197,000 people at the time.
The damaging impact of these episodes is so broad because no industry or country exists in isolation. If you impose tariffs on imports, you can expect other countries to retaliate, as president Trump is now seeing. That damages the interests of your export industries and its employees. Plus there’s the impact of tariffs on the countries you target, which suffer a loss of wealth as their trade dips. As they become poorer, they buy less of your products and services.
It is for these reasons that governments around the world pursue free trade policies most of the time – at least with other countries they consider to be economically significant (governments are often less squeamish about aggressive tactics against less powerful nations, such as those in the developing world).
Protectionist agendas, such as the one now being pushed by Trump, may be politically expedient – particularly when a government is seeking favour with a specific interest group, but they don’t stack up well economically. ‘It would be the biggest self-inflicted wound since the great financial crisis,’ warns Willem Buiter of Citigroup. ‘It would be the end of the global recovery.’
Would a full-blown trade war really be that serious? Well, Gavyn Davies, the influential former chief economist at Goldman Sachs, has estimated that a global trade war could knock up to 3 percentage points off growth in the world economy over the next few years. With the International Monetary Fund currently predicting global economic growth of 3.9 per cent a year in 2018 and 2019, that’s a pretty big hit.
Hence the nervousness of financial markets, which view the prospect of diminished company earnings during a period of slower-than-expected economic growth with some trepidation. Some sectors are in the firing line to a greater extent than others, argues Jason Hollands, managing director at wealth manager Tilney. ‘Trade in base materials is at the forefront of protectionist concerns, with steel and aluminium tariffs already hiked, while manufactured goods and sectors such as automobiles also look vulnerable,’ he says. ‘By contrast, services are going to be less sensitive to resurgent protectionism.’
The problem for manufacturers in particular is that they’ll be squeezed at both ends: tariffs raise the cost of the raw materials in their supply chains while also simultaneously applying pressure on the prices charged to customers. Some businesses may have to absorb the extra costs themselves.
Phoney war possibility
In practice, however, all sectors stand to lose if a trade war really does have a dramatic impact on global growth. Those trading across borders will suffer very visibly, but domestic businesses whose customers become poorer won’t escape the fallout.
Cross your fingers, then, that all sides find a way out of the current impasse. At Schroders, Keith Wade thinks Trump is likely to find a face-saving pull-back from outright hostility. ‘China might be able to stick out the pain that a trade war would bring for longer than the US,’ he says. ‘It has more scope for fiscal support and, of course, China’s president, Xi Jinping, and the Communist Party of China will not be facing elections.’
Still, that analysis depends on the US administration taking a calm and rational step back from the brink. In a White House where 35 senior officials left during the first year of Trump’s presidency – including former Goldman Sachs banker Gary Cohn, who walked out in protest at trade tariffs – we shouldn’t take that for granted.
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