Tariff Trauma
In our recent quarterly commentary, we provided background and ongoing developments regarding US tariffs. Admittedly, the picture remains fuzzy with daily announcements sometimes whipsawing markets intraday. Global stock markets initially fell with the first announcement of retaliatory tariffs and rebounded with a 90-day pause for most nations’ tariff implementation, as well as a delay in tariffs applied to the electronics industry. Understandably, this keeps the markets on edge. As we stated earlier, however, this uncertainty will pass as country “deals” become effective over the coming months. That said, the larger, stronger, more diversified economies of China and Europe may be more difficult to come to terms with President Trump and his team. These will probably require longer negotiations, more than 90 days, but their eventual resolution will reassure markets.
Some wonder why President Trump appears to not care about the havoc he’s bringing to the business world, seemingly willing to create chaos in the marketplace to achieve his agenda. We believe President Trump thinks the US to be a truly special nation, and other countries need to pay for the privilege of doing business here. If you want access to the US market by selling goods, you need to pay the toll (tariff). Better, however, for a business to produce in the US, and President Trump encourages companies from both the US and world to set up their factories here. As discussed in the recent quarterly, President Trump and team want to change the global economic order. The US allows foreign goods into the US relatively friction free, but other countries don’t return the favor. He wants to lower our overdependence on foreign goods, and pressure China to change its economic policies, including state subsidies, intellectual property theft, and sending goods to the US through other countries, known as transshipment. China’s concerns include the issue of Taiwan, the US technology hardware embargo, as well as wanting the US President and his administration to refrain from disparaging remarks about China generally.
While some reshoring of manufacturing may occur, we believe the US’s stated goals regarding China are extremely difficult, if not impossible, to obtain. China’s subsidies are unlike US city or state tax breaks and other incentives to induce a company to produce in their locale. China pursues more of a private-public partnership model, where the local government takes an ownership stake in the company, and thus, shares in the company’s investment and development. The US will face major resistance trying to change this structure. Likewise, ending transshipment through emerging markets, especially the ones in Southeast Asia, will be a hurdle too high, despite holding out the stick of limiting access to the lucrative US end market. Importantly, China ranks as the most important trading partner for both imports and exports to the region as well as providing the most capital, infrastructure, and tools at the best prices to help these economies develop. As the prior Prime Minister of Singapore indicated, it’s just not possible for Singapore and ASEAN countries to choose between the US and China. We look for these Southeast Asia countries to offer zero tariffs on US goods to appease Trump and possibly offer some limits on Chinese transshipment to the US market, but we don’t think there will be any appetite to cut off their China trading relationship to a significant degree. Moreover, the transshipment model provides a key cog in many emerging economy engines and can’t be removed at this stage of their development.
Distressingly, neither the US nor China show meaningful signals to compromise or steps to reconciliation at the time of this writing. The US continues to lift tariff rates with the latest announced top rate of 245%, while encouraging other countries to impose higher tariffs on China, believing China’s much greater export dependence puts the US in a superior position. Meanwhile, China promises to “fight to the end” using asymmetrical retaliatory tactics, such as placing export controls on refined rare earths, and requiring other countries to do the same, understanding the US military’s dependence on these metals. Some worry that with China losing access to the US market, the country could use its position as major US creditor to dump US treasury and agency bonds. Known as the economic nuclear option, this could significantly lift US interest rates, harming the US economy. We think this very unlikely. Losing access to the US market, while painful, doesn’t ruin the Chinese economy, and while China has reduced US debt holdings, it’s been gradual, over a period of several years. Using their creditor status as an economic weapon reduces their reserves value, drives up the value of the yuan, and China would incur the wrath of other countries by pulling down the value of their holdings of US debt. Notably, the likely resulting yuan spike hurts their trade relations with many emerging countries, potentially damaging other trading relationships in the process, running counter to their strategy of creating solidarity against the US. Thus, we don’t look for China to pursue this self-inflicted wound in an effort to hurt the US. True, these ultra-high tariffs and other retaliatory measures, if implemented long-term, will cause significant near-term supply chain disruption, and potentially spiking near-term inflation. The markets understand this. Witness Apple’s stock first suffered with the retaliatory tariff announcement, but has since rebounded after the tariff pause on electronics, including those from the PRC. Despite efforts to diversify, Apple still produces an estimated 90% of iPhones and other electronics in China.
Some worry the amplified rhetoric between the two countries risks moving from economic cold war to military hot war, with Taiwan potentially the flash point. Taiwan relies on imports of oil, coal and natural gas for 96 percent of its power. It also imports around 70 percent of its food supply. Fearmongers believe a blockaded island would have no choice but submit to China. Maybe, but this represents an ultra-risky strategy by Beijing, and a move of questionable effectiveness with freedom of navigation provided by the US 7th Fleet.
Notably, both countries seek a supporting coalition. The US demands support from other countries through tariff threats, while China’s strategy appears to be using a “charm” offensive focusing on Europe and ASEAN, especially. Sooner or later, however, both Superpowers will have to begin meaningful negotiations with each other. We think the world’s third economic power, Europe, will play a major role in bringing the two countries together. Europe will not choose either, needing the US end markets, but also needing China’s production materials. The EU also fears a ramp in finished goods imports from China. No longer allowed in the US, China may flood the EU markets. Truly, Europe views a compromise between the US and China as imperative, as the continent expresses no interest in decoupling from China to appease the US. Although nationalism will probably drive more short-term geopolitical muscle flexing and posturing by both the US and China, we believe a trade agreement will eventually occur.
Europe itself will also be a tough negotiator with the US. Although also depending on the US for sizable exports highlighted by the auto industry, estimated at over $50 billion a year considering both vehicles and auto parts, Europe’s $20 trillion economy will also survive the US tariff threat. Europe, like the US, features a high services component at over 70% of GDP. Thus, reduced exports, while important, will not ruin this economic block either. Importantly, the continent signaled an attitude sea-change recently by significantly stepping up fiscal stimulus, especially in Germany, where fiscal restraint reigned historically. Combined with greater monetary accommodation we anticipate an improving economy in the EU, at least modestly, even with tariff-damaged trade. We look for the US to extract some trade concessions from Europe, but probably not as dramatic as the US administration seeks. Ultimately, the US and Europe will also come to the negotiating table, since neither wants a long-lasting, harmful economic relationship.
Some wonder if the US will have any friends left after this administration’s heavy-handed tactics, but like personal relationships, America’s wealth guarantees “friends” or at least ongoing relations. We reiterate that although the timing remains elusive, the recent violent equity gyrations will calm, with less numerous and chaotic Administration announcements in time. We look for the ultra-high tariffs to be brought down, and as relations improve between the world’s three greatest economies, a more conducive business climate will materialize. Companies will again have the confidence to hire, invest, and grow. This should lift corporate earnings and set equity prices back on a sustainable, rising trend.
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