By Fred Dunlap
At midnight last night Trump dropped the hammer on the Chinese, raising 10% tariffs to 25% on $200 billion in Chinese exports. Markets have been coping with this possibility all week, alerted (as usual) by a Trumpian Tweet which landed on every smart phone last Sunday.
Was it a warlike move? Or was it a justified response to a shifty economic adversary who suddenly decided to move the goal posts?
Negotiations in prior weeks had been encouraging or so it seemed… And it’s upon that complacent backdrop that this development fell, abruptly changing the mood of a market that seemed poised to reach new highs.
Not surprisingly, US equity indexes and Treasury yields have retreated since Monday’s market open. Valuations have pulled back 4% since the prior Friday close. And market futures this morning remain volatile with the indexes looking to shed another 40-50 basis points.
Though markets might open lower today, the mood is eerily serene, particularly given the momentous developments last evening. This Mandarin Moment should surely have inflicted more uncertainty into a market…one that just hates uncertainty.
What could be the cause for such tranquil behavior?
Rational Thinking and the Expectation of Predictable Outcomes
While no investor is pleased by this week’s turn of events, most still feel that a deal will eventually get done–because the alternative (for both countries) is a losing proposition.
Though tariffs are now higher, negotiators from China and the US continue to meet today in Washington, stoking an air of investor optimism that both sides will now scurry to reach a conclusion.
But talks have been going on for 15 months. And it’s unclear really how close these two economic gorillas are to an agreement.
What is clear is that His Trumpness has heard enough. He’s tired of the meandering nature of the dialogue. And if the Chinese did try to pull a fast one last week, Donald might now be pissed off. And that dynamic will become problematic for the Chinese, as we will discuss below.
A Milestone of Sorts…
This week, one of our Dunlap Investment Newsletter subscribers alerted me to a milestone. He had been perusing some of our older newsletters in the archives on the DIN website. He told me that, since the inception back in 2014, I had written 99 newsletters to this point!
So this is the 100th Dunlap Investment Newsletter.
To that, I want to say THANK YOU to all of you for your interest and support of the Newsletter over the years. Whether you are a recent subscriber or one who was reading back in 2014, I appreciate your traveling along with me as we continue to monitor and document the macro-economic history of our globe. So thank you!
Now let’s get back: to China, to the Trade War, and to Trump’s Tariff Gambit!
The China Syndrome
The resolution of the Trade War with China remains elusive this morning. How long it will go is anyone’s wager. But there are key factors worth examining, which will play into the eventual outcome. Reviewing those can help place some context on the most likely scenarios. Let’s take a look.
What Just Happened
Trump imposed a higher (25%) tariff on $200 billion in Chinese exports coming to the United States. This will NOT impact goods which are already in transit to the US (a 10-12 day journey), but will apply to any new goods being shipped after midnight last night. The price/cost impact of these tariffs, therefore, will not be immediately felt for another 1-2 weeks.
Trump imposed these tariff increases (from 10%) out of frustration from what he perceived was:
- a slowing of progress on negotiations, and
- evidence that the Chinese were reneging on previous commitments
Trump also threatened the potential of a 25% tariff on the remaining Chinese exports ($325 billion) if the Chinese didn’t 1. concede back to previously agreed terms and 2. work quickly toward a conclusion.
The timing for initiating this additional tariff hasn’t yet been determined.
China’s Immediate Response
Upon the enactment of US tariffs last night, China announced that “China would take unspecified countermeasures in response.”
Hmmm…that sounds scary. Perhaps even ominous.
But their negotiators didn’t pack up this morning and take one of AOC’s trains back to China… No, they are still in Washington today, meeting with US negotiators.
That kinda makes China’s comments less frightening.
Global Reach of the Gorilla War
Negotiations and trade war worries have roiled US and China markets throughout the last 15 months. This week’s market trading has been no exception, as both US and Chinese stocks have suffered.
But the carnage hasn’t been restricted to these two countries. European markets have responded similarly, as have Emerging Markets. Yes, this is truly a global economy with global trading partners. The rest of the world is also impacted (even if only tangentially), watching intently to see if these two gorillas can reach a compromise.
Don’t Judge Too Quickly – These Tariffs Might Not Be Such a Bad Thing
Trump held a rally in Panama Beach, Florida the other night. Among other things, Trump addressed the impending tariff hikes explaining that he had to do it, because “China changed the deal.” He went on to crow about how this wasn’t a bad thing, because the tariffs would bring in $100 billion to the US as new tax revenue.
If you watched any cable TV, you heard repeatedly that the new revenue would actually be paid by US consumers, because they would be paying higher prices on Chinese imports, caused by the tariffs.
What do I think? I think they are both right…and they are both wrong.
If selling volume remained the same, in spite of these tariffs:
- China would charge the same price for their exports
- China would sell the same amount of goods, and
- US consumers would bear the full cost of the exports.
But what if the tariff-laden prices then made other competing goods (from other countries or from companies in the US) more competitive? Then:
- Might the sale of Chinese goods to the US go down?
- Might the US consumers then avoid the China-sourced tariffs?
And if this were to happen, might China then reduce their own export prices to regain their competitive position?
If the impact of recent tariffs causes a slowing of Chinese sales:
- new US revenue from tariffs would be less than what Foggy estimated
- US consumers would bear much less cost from the tariffs (because the purchase of Chinese goods would be fewer), and
- China would feel the pain of: fewer sales and/or lower prices on goods sold.
So both Trump and the media are right and wrong, but most importantly, China would be hurt either on profit margin or total sales, or both.
How then do we Handicap this Fight?
To speculate on how this trade stalemate will end requires an assessment of the strengths and/or vulnerabilities of each fighter in the ring. Let’s do that on a categorical basis.
Political System
Trump has to deal with an election in 2020. He also has a few other distractions, brought to him continually by the likes of Nancy Pelosi, Chuck Schumer and Jerry Nadler…
China has no elections, which on the surface, looks easier. But Chairman Xi’s position should not be considered impenetrable. His life-long position is life-long provided he doesn’t screw it all up. His political system expects that the US trade dispute will not change their way of living or governing. The Chinese leaders like it their way and they expect Xi to keep it that way. Hence, the reason for the Chinese’ resistance to many/most of the trade reform measures that the US is demanding.
Economic Assessment
The US economy is humming, with:
- A 3.6% unemployment rate (lowest in 50 years)
- A 3% GDP in 2018
- A 3.2% GDP print in Q119
- A contained inflation level (April’s CPI came in tepid today)
- Low interest rates, and
- A stock market at/near all-time highs
The Chinese economy has been slowing over the past two years. It has been revived somewhat recently, largely due to massive fiscal stimulus measures applied by the Chinese government, in an effort to prop up their stagnating economy.
Vulnerability to Tariffs
The economic strength comparison above would suggest that the impact of tariffs on each economy would hurt China more than the US.
Frankly, it could get worse for the Chinese. They export $525 billion to the US each year. We, on the other hand, only export $150 billion to China. If the tariff wars get worse, the consequence to China is greater because they are more reliant on the US purchasing their exports. They have more than three times as many goods which would/could be subject to tariffs.
Innovation and Ability to Compete on an Even Playing Field
The US has led the world for a century in this regard.
To equalize the playing field to some degree, many countries have historically slapped tariffs on US goods which were/are sold internationally. Why? Because their home-grown products have often been inferior–the tariffs they apply are then a measure to (increase the price of and) reduce the competitiveness of US exported products.
This has been true in China as well. China has made significant progress with their own tech development over the last two decades (some of which has been via stealing intellectual property…). That said, their built at home products still cannot compete effectively with products from other countries (including the US). More than anything else, in my opinion, this is China’s greatest problem with agreeing to a US trade deal.
Why? More than IP theft… More than Joint Venture requirements… China fears a true free enterprise structure, where the Chinese market would be open to free international trade. Why? Because it would require a fair and balanced playing field. One where there are no tariffs… One where companies from any nation could come to China and sell their goods…
Why would that be problematic to the Chinese? Because China-based companies have inferior products and would lose badly to their international competitors. Without the benefit of Chinese tariffs on goods coming into China from other countries, they wouldn’t stand a chance of competing effectively if they opened the Chinese market to outside competition.
Time is NOT on China’s Side
Much has been said about China’s philosophy of “playing the long game.” It is widely held that China thinks in terms of centuries, whereas the US thinks in terms of two- and four-year political cycles. Pundits profess that the Chinese will just stall and wait us out on a trade deal. Perhaps wait for another US President to be elected…someone more reasonable than Trump.
If that’s the case, then (after imposing tariffs last night) why did Trump say “there’s no need to rush” on the negotiations?
Answer: because the tariff clock is now ticking.
Politics aside, there are other reasons why China might be much more impatient to resolve this trade dispute.
As mentioned above, the trade fight between these two economic gorillas is having ramifications in other international markets. The world is watching to see how and if this gets resolved, as they too have interests in China.
Risks to China’s Role in the Global Supply Chain
Companies from the US and other international countries have long taken advantage of the cost of labor arbitrage in China. For decades, companies have set up operations/factories in China to gain a lower cost advantage. While this has been good for those corporations, it has also been very beneficial to the Chinese economy, providing jobs and improving the quality of life for Chinese citizens.
Over time, wages have risen in China due to this international demand for workers. In fact, they have risen to the point where wages in China are no longer the lowest available wage. Places like Vietnam and Thailand now have lower wage opportunities, all of which raises an interesting question…
Where will CEOs choose to position their Supply Chains?
The trade dispute with China is on every CEOs agenda these days. No quarterly Board Meeting is happening without a time segment reserved for the Board of Directors to debate/discuss the status of China.
As this trade dispute has worn on, it is becoming more apparent that a trade deal may not come soon. Moreover, even if a deal gets reached, the tensions from the fight portend that the battle (between the US and China) will be ongoing into the future. Why? Because, as this fight has ensued, it has become very apparent that the US/China issue is not only economic, but also about national security.
So what then is a CEO to do?
Trust me that every CEO who has an operational presence in China (or an interest in establishing one) is currently considering their options…
Might they be better off setting up operations in Vietnam or Thailand? Might they consider even moving their current operations in China to one of these countries?
What would be the benefits?
- Lower wage cost
- Remove themselves from US tariff risks associated with China
- Move to a smaller, less geo-politically consequential nation, where an economic Cold War with the US is less likely to develop.
Yes, this is what is being discussed today in Board Rooms all over the world. And the longer this US/China trade dispute continues and intensifies, the more likely CEOs will make planning decisions that don’t include maintaining operations in China.
A widespread migration of supply chain operations away from China would have catastrophic consequences to Chinese employment levels. If I were Chairman Xi, I would be factoring in these downside risks, when considering how obstinate he can remain to a deal with the US.
No, time is not on China’s side. And I think Trump knows that.
I think Trump knows that tariffs (now in place) will erode China’s economic strength. Moreover, the continued strife of an unresolved trade dispute threatens an exodus of corporate supply chains, more and more as each month passes.
An added variable for the Chinese to manage right now is the irritability of Trump. After reneging on some deal terms, they have pissed off the guy in the Oval Office and likely vanquished any goodwill they might have hoped for from him.
Foggy has always rejoiced in his unpredictable nature. But with the “moving the goal post” stunt last week by the Chinese, he might now become even harder to deal with. I wouldn’t be surprised if Trump tries to satiate his anger by taking it out on the Chinese via some even more difficult deal demands.
If this Trade War gets even Uglier, What’s likely to Happen?
The menu of retaliatory moves by China in response to last night’s US tariffs are:
- They could slap a 25% tariff on about $60 billion of US exports
- They could cancel major purchases from the US (farm and energy products)
- They could reverse their plan to lower tariffs on US cars
- They could possibly favor non-US firms for access to financial markets, and
- They could employ some dirty tricks, such as tightening their Customs Checks or making life administratively difficult for companies like Apple, Caterpillar or Boeing.
The US has some methods to escalate things further too–we could slap tariffs on the rest of Chinese exports ($325 billion).
The strength of our economy would most likely allow us to cope fairly well with the tariffs. As an example, last night’s tariffs (if they remain in effect interminably) are estimated to have the following impact:
- Increase inflation by 0.2% annually.
- Decrease GDP by 0.2% annually
Notably, we have very moderate inflation levels presently and robust GDP growth–therefore, these two detracting factors listed above should not be overly concerning.
Perhaps that’s why the US stock markets have not collapsed this morning? Perhaps investors are getting acclimated to the notion that the US economy is hearty enough to withstand the current level of tariffs and the general uncertainty of an unresolved China trade deal?
On the Way Out…
Though the Chinese are revered for their patience and constant focus on the longer term play, I would suggest that Chairman Xi should decide to move much more quickly to resolve a trade deal with the US. Time is NOT on his side, in my view, for the perils and complications (discussed above) will get worse if he allows this process to languish.
I am sure Chairman Xi rues the day that Donald Trump came into office. I imagine he longs for the days with the 4-5 US Presidents that preceded him…days when nobody was focused on the sweetheart deal that had been proffered to China…days when China had an unfair advantage.
Yes, I’m pretty sure that Xi isn’t a fan of Donald Trump. Not a bit, I imagine. For Trump appears to be breaking up a good gig for the Chinese.
But with that party now over, it’s time for Xi to make a decision…to acknowledge that sweetheart deals are over, and that he needs now to select a lesser deal. But, from my distant planet, he better hurry up and pick it. Because it looks like it’s going to get lesser by the day…
With that, I will sign off on this 100th Dunlap Investment Newsletter. Thanks again to all of you for your interest and support.
Stay thirsty my friends.
Freddie Deeeeeeeeeee