Corporate America will pass down the pain of new tariffs

After months of both Chinese and U.S. officials indicating considerable progress had been made, trade talks between the two countries have taken a big step backward.

At 12:01 a.m. ET on Friday, after meeting with Beijing's top trade negotiator Vice Premier Liu in Washington on Thursday, the Trump administration announced a new round of tariffs. 

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Noting progress in trade talks has been “too slow,” and reports that China reportedly reneged on earlier concessions, the president this week announced an increase in tariffs on the already targeted $200 billion worth of Chinese imports from 10 percent to 25 percent, as well as proposing additional levies on the remaining balance of $325 billion, potentially “soon.”

To the president’s point, the U.S. and Chinese officials have been in negotiations now for more than 10 months, well surpassing the original March 1 deadline. While the Trump administration has been clear it remains committed to reaching a compromise, officials felt it was necessary to increase the pressure on Beijing or run the risk of drawing out talks indefinitely. 

“They broke the deal," President Trump said ahead of the Friday deadline at a political rally. He reassured the crowd: "Don't worry about it ... there's nothing wrong with taking in $100 billion a year" in tariffs. 

China's vice premier arrived in Washington on Thursday to continue trade talks. Ahead of the discussions, however, the country’s officials had issued a warning of retaliation if President TrumpDonald John TrumpAmash responds to 'Send her back' chants at Trump rally: 'This is how history's worst episodes begin' McConnell: Trump 'on to something' with attacks on Dem congresswomen Trump blasts 'corrupt' Puerto Rico's leaders amid political crisis MORE indeed followed through with his threat to boost levies on Chinese goods by the end of the week.

Following the actual announcement of higher tariffs on Friday, Beijing immediately responded, expressing “deep regret” over the development and noting plans to “take necessary countermeasures.” 

At the same time, however, officials said they hoped the United States “will meet us halfway, and work with us to resolve existing issues through cooperation and consultation,” suggesting a similar, lingering desire to potentially reach a deal despite the recent setback.

As an export-dependent economy, China is disproportionately feeling the pain from the ensuing trade war, but the U.S has not escaped unscathed, creating an economic incentive on both sides to finalize a trade deal in the coming days — aside from the obvious political motivations. 

According to the Institute for Supply Management (ISM), manufacturing activity in the U.S. slowed from 55.3 to 52.8 in April, the lowest level since October 2016, exacerbating the broad-based decline over the past eight months from a recent peak of 60.8 in August 2018. 

Trade barriers have resulted in a similar decline in activity oversees. According to the Purchasing Managers Index (PMI), Chinese manufacturing activity bottomed out at 49.9 in February, the third consecutive month of contraction, before rebounding to 50.8 in March and slowing down again in April to 50.2. 

A further deterioration in trade relations, including a fresh round of tariffs, will likely exacerbate manufacturing-sector weakness both at home and abroad.

More broadly, Chinese GDP rose 6.4 percent in the first quarter, unchanged from the quarter prior, maintaining the weakest pace in nearly a decade. Escalating trade tensions are at the heart of the weakness. 

The U.S., meanwhile, has not escaped unscathed from last year’s restrictive trade policies. While growth remained solid in the U.S., the 2017-2018 tariffs shaved off roughly two-tenths of a percentage point from domestic growth. 

Going forward, an additional round of trade levies would expectedly intensify the negative impact in Beijing as well as here at home, potentially shaving three-tenths of a percentage point or more from 2019 GDP. 

Early on, many American businesses struggled to pass on cost increases as a result of tariffs without the risk of losing market share.

At 25 percent, however, it will be increasingly difficult for corporate America to entirely absorb higher prices without an equal offset in higher efficiencies elsewhere resulting in either direct cost increases or a longer-term decline in hiring, wages or both.

At the May Federal Open Market Committee press conference, Federal Reserve Chairman Jay Powell expressed optimism for the domestic outlook in the wake of reduced international risks, particularly amid noticeable “progress” in U.S.-China trade talks. 

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After this week’s setback, such positively may prove misplaced, as many now fear a further implementation of tariffs could result in domestic price increases as well as the importation of further inflation from abroad. 

While possible, it is more likely that restrictive trade policies will undermine global growth, reducing the demand for international goods and services, raw materials and commodities in general, translating into more benign price pressures world-wide. 

Undermining the chairman’s more-positive view of international cross-currents and optimistic outlook for domestic growth, a further deterioration in U.S.-China trade relations is likely to exacerbate volatility in global equity markets, compound future risks to domestic growth and reinforce the more dovish argument among committee members in support for increasingly accommodative policy sooner than later. 

Lindsey Piegza is the chief economist for Stifel Fixed Income. Follow her on Twitter: @LindseyPiegza.