Keeping Score on U.S./China Trade

Investors should watch the growing impact this escalation has on the U.S. consumer, the profitability of Chinese exporters and outlook for monetary policy.

The latest salvo in the U.S./China trade war will increase the current tariff level of 10% on $200 billion of goods to 25% and the president has threatened another 25% on an additional $325 billion in goods. The impact of the first two rounds of tariffs has largely gone unnoticed, but the current and future rounds will likely be a different story.  Investors should watch the growing impact this escalation has on the U.S. consumer, the profitability of Chinese exporters and outlook for monetary policy.

U.S. TRADE WITH CHINA
Source:  FactSet as of March 31, 2019.

The U.S. is China’s largest trade partner, importing $522 billion worth of goods over the last year. In that same time, the U.S. has exported just $114 billion to China, resulting in a goods trade deficit of over $400 billion (most economists agree the trade deficit is driven more by differences between U.S. savings and investment levels than actual trade practices, but the deficit does offer a measure of potential immediate pain from tariffs). The initial two rounds of tariffs raised the cost of Chinese exports by $32.5 billion, but these costs were more than offset by a 7% depreciation in the CNY/USD exchange rate – and, the exchange rate relief applies to all imports, not just those hit by tariffs. To fully cover this latest tariff increase, the yuan would need to depreciate another 5% vs. the dollar. It’s certainly not beyond the realm of possibility if tariffs were to escalate further in round three. 

The tariffs that just went into effect on the $200 billion of goods will not impact any goods that are already in transit. It takes roughly 25-30 days for goods to ship from China to the U.S., so that becomes a key window to get a deal done before the higher tariffs hit. This essentially buys both sides a few more weeks of negotiating room but doesn’t quite get us to the G20 summit in Osaka June 28 and 29.   

U.S. – CHINA TRADE SCORECARD

Source: U.S. Bureau of Economic Analysis, Office of U.S. Trade Representative and Bloomberg as of May 14, 2019.  

While tariff revenues have jumped sharply over the past year, we see little evidence so far that U.S. consumers have paid the price. That may not last. Both headline and core CPI were below estimates for April and have been trending lower on a year-over-year basis since last July. Import prices were down year-over-year in April.  As suppliers run out of alternatives to absorb tariff increases, higher prices may show up in consumer inflation data, but they haven’t so far. The current $200 billion in goods already includes some consumer products such as refrigerators, handbags and luggage, while the remaining $325 billion will extend to include toys and electronics, including cell phones and televisions. A looming 25% tariff on these goods will be difficult for U.S. consumers to avoid.

U.S. TARIFF REVENUE
Source:  FactSet as of March 31, 2019.

Judging by equity market performance, it is clear that China has suffered more in the trade conflict so far.  There may, however, be policy responses on both sides.  Since tariffs went into effect at the end of 1Q18, the S&P 500 is more than 7% higher while China’s CSI 300 index is down nearly 7%. Of course, this may also reflect concerns about China’s slowing growth too. While the impact of the first two rounds of tariffs on Chinese exporters has largely been offset by CNY depreciation, profit margins are likely to be under much more pressure at a 25% tariff level.

EQUITY MARKET PERFORMANCE (MARCH 2018 = 100)
Source:  FactSet as of May 14, 2019.

The monetary policy impact of tariffs remains to be seen.  On one hand, higher levies should put upward pressure on inflation by raising import prices. However, the Fed may focus more on the potential negative consequences to economic growth from a potential drag on consumer and corporate spending. This could tilt the odds toward a rate cut, which have shifted notably higher recently. Given the trade surplus that China has with the U.S., higher tariffs present more of a risk to economic growth there than in the U.S. Any further weakness in Chinese growth is likely to be met with additional stimulus from the PBOC and possibly fiscal stimulus as well.