The U.S. and China have been sparring over trade for more than a year. As of this writing, the Trump administration has placed tariffs on about $250 billion in Chinese imports and imposed limitations on Chinese tech giant Huawei based on security concerns; China has set levies on $110 billion in U.S. goods and looked to other countries for soy beans and other agricultural products. In May, high-profile negotiations broke down, and President Trump increased tariffs on $200 billion in Chinese goods from 10% to 25% and threatened an additional $300 billion (essentially the balance). However, after Trump and Chinese President Xi Jinping met at the G-20, the two parties announced a “truce” and sought a return to the bargaining table.
Clearly, the conflict has been a key source of angst for investors, with market swings often based on the latest trade-related comments or evidence of impacts on the broader economy. It has also been somewhat damaging to both countries thus far, with U.S. exports to China falling 19% or $10.2 billion year-over-year through May, and Chinese exports to the U.S. easing 8.7% or $15.3 billion.1
Conflict Has Dampened U.S.-China Trade
Exports: Year-Over-Year Change (%)
Looking at the impact on U.S. families, the New York Federal Reserve found that the 10% tariffs introduced in 2018 on $200 billion of U.S. imports from China cost the average household $419 per year, including an added indirect tax burden and a “deadweight” or “efficiency loss” where goods are substituted for those of another country at a higher price than without any tariffs. With the increase to 25% in May, the direct tax cost eased somewhat, but the deadweight cost jumped, bringing the total annual cost to $831 per household per year.2
However, the toll goes beyond direct taxation and substitution of goods from other countries. Uncertainty around tariffs (both in relation to China and other U.S. trading partners) has chilled capital investment as companies are reluctant to commit funding amid uncertainty. On average, economists anticipate global growth of 3.3% in 2019 and 2020, down from 3.7% in 2018 due to pressures including trade friction, while China is expected to grow 6.0% and the U.S. 1.8% next year.3 With potential U.S. tariffs on (and a Chinese response to) another $300 million in Chinese goods, global growth could be reduced by 0.4% for 2020, while China and U.S. growth could ease 80 and 50 basis points, respectively, according to Fitch Ratings Services.4
There have been economic offsets to the negative impacts of trade conflict: The Chinese have increased stimulus, including loosening borrowing rates, cutting taxes and hiking spending on infrastructure, while the Federal Reserve is maintaining a dovish stance after its last rate hike spooked investors late in 2018. The nature of the global supply chain has also allowed for workarounds. Unlike the classic tariff era, many products are “made” (manufactured and assembled) in multiple countries; for example, some companies have been moving assembly out of China and into Vietnam or Mexico to avoid a China label and associated tariff cost. On the margin, “transshipment” of goods is allowing some producers to skirt U.S. levies, where Chinese exports make a brief stop in a third port, are minimally processed or altered, and then re-exported from the new country. The U.S. government has been working to curtail this practice.
Key Long-Term Issues
Still, reliance on such mechanisms is a far cry from the establishment of meaningful resolution to the dampening influence of trade uncertainty. On balance, we believe that China and the U.S. will reach some kind of accommodation—the incentives are very strong in this direction. But if that happens, it seems likely that longstanding issues will continue to be the source of strain and periodic flashpoints in coming years, including the following:
Intellectual property: Over the past decades, the U.S. and others have accused China of stealing intellectual property from international companies, requiring that they transfer technology to Chinese counterparts as a cost of doing business, and otherwise only loosely enforcing intellectual property protections. Xi’s government has taken steps to clamp down on theft and reduced requirements that foreign companies have a domestic partner to do business in China (a key source of intellectual property “leakage”), but the U.S. wants more.
Security/technology: The transition to 5G technology is likely to be game-changing for many industries, enabling autonomous vehicles and accelerating the “internet of things.” With its Made in China 2025 initiative, China has made it clear it wants a dominant place in this new world. However, the U.S. has major security concerns regarding the spread of Chinese tech and influence, which is a key reason for current limits on Huawei, the Chinese tech company.
Structural change: The U.S. wants China to curtail subsidies to domestic companies and open up markets. This has been part of the process of modernization in China, but it has come at a snail’s pace, and the U.S. is looking for meaningful liberalization. This would entail changes to Chinese laws, and the Xi government has objected that the U.S. is seeking to interfere in its domestic affairs.
To some degree these issues have come to a head due to the views of the Trump administration, so some believe that they could ease if there is a change of leadership in next year’s presidential election. But that probably underestimates the broader U.S. consensus that is emerging around tough China policy, as free trade advocates in both parties have taken a back seat to more populist voices. Moreover, the geopolitical rivalry between the U.S. and China appears to be accelerating, reflected in nervousness about China’s economic leverage through its “belt and road” development initiative and assertiveness in the South China Sea, as well as potential tensions related to Taiwan and Hong Kong.
Also not to be discounted is the broader context of fission in the global trade landscape. The U.S. isn’t just in conflict with China, but has ongoing disputes with many of its trading partners and is welcoming trade-related complaints from many U.S. companies. For the globalization trend, the bloom is definitely off the rose, as Britain and continental Europe grapple with the pressures associated with displaced workers and open borders and as trade negotiations become more fragmented. Overall, protectionist practices have been on the rise throughout the world.
Globalization Under Pressure
Number of New Trade Interventions Each Year
Source: Global Trade Alert, as of June 30, 2019. Adjusted for reporting lag.
Prospects and Impacts
With so many issues in the U.S.-China relationship, there’s risk that the parties will try to be too ambitious and seek to solve all of them at once. In our view, a constructive scenario would be an agreement that deals with doable issues now, and provides a structure for future progress. However, trust remains a key issue, as China is seeking the immediate removal of all sanctions, while the U.S. wants them to remain in place with the ability to apply new levies if China reneges.
If a “no-deal” scenario emerges, the markets will likely be disappointed. Our Asset Allocation Committee has consistently identified the trade conflict as a key danger to its best-case “soft landing” scenario. Tariffs would continue to hurt China, the U.S. and their trading partners. Meanwhile, life could become more difficult for U.S. companies operating in China, whether because of regulatory frictions or the potential for a popular backlash against foreign brands, as has occurred in some of China’s previous trade disputes. Longer term, you may see the development of a bifurcation of global trade, with the U.S. and China operating in two different spheres, including, importantly, two different infrastructures for 5G technology.
That said, even if there is a deal (whether just face-saving or with teeth), there will likely continue to be tensions surrounding the issues we’ve described. They are deep-seated, with geopolitical dimensions, and could create underlying noise and uncertainty for the foreseeable future. In the end, individual companies will adapt, but investors should remain alert to primary and secondary impacts as the world order evolves.