Stephane Monier: The Predictable Consequences of Trade Wars

The Trump administration clearly sees the current strength of the U.S. economy as a window of opportunity to counter China’s rise as a superpower.

Whatever the short-term cost to the U.S. economy. In order to counter China’s economic rise, the present U.S. administration has weaponized trade with the goal of shutting out China’s supply chain, even if that leaves the American economy and markets reeling to adjust.

When China joined the World Trade Organization (WTO) in 2001, the U.S. and Europe expected reforms to create an increasingly western liberal economy. As we mark the 30th anniversary of the Tiananmen Square massacre, the U.S. tariffs show that the relationship has significantly changed in recent years.

«Xi Jinping is signing new agreements in Moscow with his ‹best and bosom friend› Vladimir Putin»

There is no sign that China and the U.S. are any closer to finding common ground in their disputes. On the contrary, the rhetoric has worsened with the U.S. ban on its technology firms from doing business with China’s telecommunications company, Huawei, over security concerns. Formally, the next meetings will be at the G20 Summit scheduled for 28-29 June in Japan, where we don’t expect a breakthrough. In the meantime, China’s President Xi Jinping is signing new agreements in Moscow with his «best and bosom friend» Russian President Vladimir Putin.

The U.S. tariffs on China are already disrupting trade flows globally as suppliers and importers find routes around the mutually-imposed tariffs. U.S. imports from Vietnam, South Korea, and Taiwan have increased over the past six months while China has increased its exports to those three countries. In the circumstances, we are watching carefully other trade threats from Donald Trump who has made reducing the U.S.’s trade deficit into a cornerstone of his presidency. The International Monetary Fund has argued that the U.S./China tariffs will cost $455 billion in lost production next year. Tariffs look like the wrong weapon for the wrong target.

«The Trump administration is trying to use tariffs to solve every problem but HIV and climate change»

Trump is also targeting the EU’s trade surplus with the U.S., affecting German carmakers with a list of imported parts worth $53 billion that may be subject to tariffs unless talks can make progress. In July, the WTO will rule whether the U.S. can go ahead with $21 billion of tariffs on EU goods related to a dispute over subsidies to Airbus (a similar WTO case may rule against Boeing in 2020).

President Trump is increasingly relying on tariffs as a negotiating weapon in its international relations. The U.S. had threatened in May to start a new front in its trade war by applying a 5 percent tariff on all Mexican imports, with a 5 percent rate raised in increments at the beginning of each month to a 25 percent tariff in October. President Trump linked the tariffs with what he had described as «the illegal inflow of aliens» from Mexico.

The danger is that the Trump administration «is trying to use tariffs to solve every problem but HIV and climate change,» Republican Senator James Lankford said last week.

«The tariffs on China are already forecast to increase inflation in the U.S.»

Mexico relies on the U.S. market for nearly 30 percent of its Gross Domestic Product GDP), so any new tariffs on its exports would erode profit margins and undermine jobs. From the U.S.’s economic point of view, it may look an odd time to start additional trade disputes. The logic in the Mexico case, according to the White House statement, was that high tariffs on Mexican goods mean «companies located in Mexico may start moving back to the U.S.» leading to «a massive return of jobs back to American cities and towns.»

The tariffs on China are already forecast to increase U.S. inflation as the higher costs of imports hit household spending and businesses’ supply chains. That has knock-on implications for U.S. GDP, which would be compounded by any weakening in equity markets.

The threat of Mexican tariffs also surprised since on May 17 the U.S. agreed with Canada and Mexico to lift tariffs on imports of steel and aluminum and drop their related disputes at the WTO. The duties were blamed for stalling the ratification of the U.S.-Mexico-Canada Agreement (USMCA), signed last November.

«These fresh tariff-induced uncertainties undermine Trump's credibility in negotiations with China»

Under the still-in-effect NAFTA (North American Free Trade Agreement) between Mexico, Canada, and the U.S., most trade between the three economies is duty-free while globally the U.S.’s average tariff was 1.7 percent in 2017, according to the World Bank. Mexico is the largest supplier to the U.S. in vehicle and car parts and machinery, making it difficult for U.S. manufacturers to find alternative suppliers for parts that in the course of their production cross the border multiple times (and so paying a tariff each time).

These fresh tariff-induced uncertainties have important short-term implications because they undermine the Trump administration’s credibility in negotiations with China.

«An impact that has surprised everyone»

As the American political calendar moves toward 2020’s presidential election, it looks likely that President Trump wants to be seen by his electorate moving from «Tariff Man to Dealmaker». This is a dangerous approach as manufacturing and economic output is dependent on the uninterrupted trade flows established over the past few decades.

While it seems that Trump may be more reluctant to treat his closest economic partners and allies in the same way as China, global trade remains highly sensitive to disruption. As we have pointed out before, it remains the single greatest threat to the world’s economic activity, with an impact that has surprised everyone with its speed and spread.

Stephane Monier is the Chief Investment Officer (CIO) at Lombard Odier Private Bank. You can find an extended version of this essay here.