Will the trade war knock the US economy off course?

Richard Flynn, managing director of Charles Schwab, examines the impact the trade war is having on the US economy.

There are a lot of different views as to whether the current trade war between the US and China will ultimately serve the purpose of getting China to back down from its more aggressive practices around intellectual property theft or forced technology transfer.

While it is impossible to tell whether Washington’s methods are appropriate to solve that problem, investors do need to analyse the impact that tariffs are having, and will potentially have, on the US economy.

The effect on inflation is one example. We are already starting to see the consequences on goods that have been most directly impacted by tariffs, whether it’s in indices such as the Consumer Price Index (CPI) or Personal Consumption Expenditures (PCE).

There is a significant probability that current tariffs will drive up inflation and, if the additional proposed tariffs on the final $300 billion in Chinese goods kicks in, it is reasonable to add an even greater rise in inflation statistics. These figures are meaningful given that we’ve been in a low-inflation environment.

Equally, some estimates predict a drag on US GDP of -0.30% based on already-imposed tariffs, with a significant 0.4% additional fall expected if the remaining proposed tariffs on Chinese imports are imposed.

Recent data releases have added to concerns about the near-term trajectory of economic growth. First-quarter GDP was stronger than expected, but helped significantly by inventories and net trade, both of which are expected to reverse in the second quarter. Since that release, the April readings on industrial production and retail sales were both big misses, and, according to the US Federal Reserve, capacity utilisation dipped again.

The near-term impact on the market is easy to see but determining the longer-term economic impact is more difficult. That said, multiple recent studies—including by the National Bureau of Economic Research and Goldman Sachs—have basically settled the question of who bears the greatest cost of the tariffs: US companies and their consumers.

Predicted declines in economic data are largely based on the direct impact of Americans paying higher prices owing to the tariffs. As the US economy is nearly 70% driven by consumer spending, further tariffs could have meaningful implications for overall economic growth.

There is also concern about the hit to corporate confidence and a slowdown in capital spending plans. For now, despite a modest pullback, business confidence remains fairly high (especially among smaller companies), but most measures haven’t taken the latest rise in trade tensions into account.

Already, we’ve seen the ISM Manufacturing index indicate that the sector is growing more concerned about the trade uncertainty; with the key leading indicator of new orders in decline.

We’ll be watching confidence and capital spending plans closely as the trade tensions drag on, but it is hard to envision a scenario where – if there is not a comprehensive deal with China – animal spirits can be ignited, business confidence can be lifted, and investment restarted. These are the indirect, but wider-ranging, effects of this trade dispute on the US.

The ongoing trade war has also caused markets to falter. Economic uncertainty has contributed to another inversion of the 10-year Treasury minus three-month Treasury yield curve, which has further alarmed investors. The bond market has been flashing warning signs since late last year, but the Fed and other markets largely ignored the red lights until recently.

Further, the drop in real long-term yields is the clearest signal from the market that growth expectations are falling as the market prices in the risk of a recession, leading Fed chairman Jerome Powell to confirm that the Fed was open to cutting rates this year.

Trade tensions will likely continue to contribute to increase volatility and the longer it drags on, the bigger the hit to economic growth, consumer and business confidence, and the stock market.

Our neutral stance around US equities suggests keeping allocations no higher than longer-term strategic targets, with a large cap bias, and using volatility for rebalancing opportunities.

For those investors who do not have broad international exposure, now may be a good time to consider areas that may feel less impact from the US-China trade dispute.

Richard Flynn is managing director of Charles Schwab.

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