Markets will arbitrate the trade war

Markets will arbitrate the trade war
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How worried should investors be about the escalation in the U.S-China trade war? 

The decision by President TrumpDonald John TrumpDemocrats ask if they have reason to worry about UK result Trump scramble to rack up accomplishments gives conservatives heartburn Seven years after Sandy Hook, the politics of guns has changed MORE to raise duties on $200 billion of imports from China from 10 percent to 25 percent and his threats to impose them on all Chinese imports represent the third round in the conflict that began in early 2018.  

Whereas the two prior episodes contributed to heightened market volatility, the response this time has been relatively calm. But this could change if the global economy falters again. 

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While some investors are clinging to the hope that a deal will be consummated this year, this may be wishful thinking. The gap between the two sides is wider than ever, and the Trump administration’s actions to impose sanctions on Huawei could turn what was a trade dispute into a national security threat.

Neither side in a hurry to strike a deal. President Trump believes he has the stronger hand because the U.S. economy is not heavily reliant on China.

However, Chinese President Xi Jinping does not want to be perceived as caving to U.S. demands, and he has recalled hardships the Chinese people endured during the long march when the Communists united the country. 

Meanwhile, higher tariffs are becoming a permanent fixture of the U.S. economy. Torsten Slok of Deutsche Securities computes that the average U.S. tariff rate has increased to 4.2 percent, which is the highest in the developed world and above that of China and many emerging economies.  

Should they remain in effect, they could impact the economy’s potential growth by lessening economic efficiency.

History teaches that once a tariff has been imposed, it is often difficult to repeal. This is so because companies that are the main beneficiaries have a vested interest to keep them in place.

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Similarly, companies (or agricultural producers) that are hurt by tariffs can appeal to the government for compensation and may be granted relief for political reasons.  

Households, by comparison, are often left to fend for themselves, and they may feel it is not worth protesting higher costs of goods.

The tariff hikes that occurred in 2018, for example, have not produced a backlash among U.S. consumers. One reason is that the Trump administration sought to lessen the impact of tariff increases by targeting imports that did not directly impact consumers.

However, this could change once the latest round of tariff increases takes hold. According to a New York Federal Reserve study, it will cost American households on average $831 annually compared with $221 in the previous round.

The added costs stem from the 25-percent tariffs on Chinese imports being sufficiently high that U.S. households increasingly will switch to providers such as Vietnam and others in Southeast Asia whose production costs are higher than China’s. Should tariffs be extended to cover all imports from China, the cost to consumers would be even greater. 

The Fed study also found that Chinese exporters have not lowered their prices to retain U.S. buyers. Consequently, the incidence of the tariff hikes has been born entirely by American producers and consumers.  

At the same time, reduced demand for Chinese products has adversely impacted the profitability of Chinese businesses. During April, for example, Chinese industrial profits dropped by nearly 4 percent, their steepest decline since December 2015, and the subsequent hike in tariffs will likely worsen their predicament.

What is surprising amid all this is how passive Americans have been to the most sweeping change in U.S. trade policy in the post-World War II era. The United States previously led the industrial countries in seeking free trade, but it is now at the vanguard of raising tariffs. 

Similarly, previous U.S. administrations sought multilateral trade agreements that established ground rules for trade, whereas the Trump administration seeks bilateral agreements that attempt to provide the most favorable deals for the U.S. 

The problem with current trade policy is it is both inconsistent and unpredictable. The change began when the U.S. government withdrew from the Trans-Pacific Partnership (TPP) after President Trump assumed office in January 2017. 

The decision was made even though the TPP would have created an effective alliance against China. One year later, the administration surprised U.S. allies — Canada, Mexico, Japan and members of the European Union — by imposing duties on aluminum and steel while using national security considerations as the justification. 

More recently, the Trump administration reversed course in May by eliminating the tariff increases on Canada and Mexico and by postponing pending tariff hikes of 25 percent on auto imports from the EU and Japan. 

While these decisions have allowed the administration to focus its efforts on China, it remains to be seen whether duties on autos will be implemented should a deal with China be consummated. 

The sweeping changes in trade policy pose a predicament for businesses and investors who seek policy clarity in making decisions. The latest data show that capital spending by S&P 500 companies filing in the current quarter slowed to a 3-percent increase from a 20-percent rise a year ago. 

This suggests that as the favorable effects of corporate tax cuts begin to fade, uncertainty over tariffs could play a bigger role in shaping capital spending decisions. Indeed, some businesses that were surveyed indicated they may postpone or cancel investment decisions until there is greater clarity on trade issues. 

The effect of uncertainty over trade is also apparent in the performance of the U.S. stock market. It is relatively unchanged over the past year, after having increased by more than 40 percent from President Trump’s election victory through early 2018, when the administration began to impose duties.

Thus far, no political leader today is inclined to challenge the president on trade policy, as both Democrats and Republicans alike favor a tough stance on China. This also means they are willing to tacitly accept the fallout of a trade war as long as the damage to the U.S. economy is contained. 

However, if the global economy falters, markets could erupt once again, as they did in December. In this respect, markets could yet become the ultimate arbiter of the trade conflict.

Nicholas Sargen is an economic consultant to Fort Washington Investment Advisors, a lecturer at the University of Virginia Darden School of Business and the author of "Investing in the Trump Era: How Economic Policies Impact Financial Markets."