Trade friction is starting to have an economic impact, which is likely to worsen in coming months. China is the immediate focus of US trade policy and it is here that the damage is already evident.
There are two different PMIs for Chinese manufacturing (one produced by a private-sector company and one by the government). For June they both showed marginally positive readings (51.0 and 51.5 respectively) that were down only slightly from May. However, the component for new export orders was weak – below the boom-bust 50 line in both cases. It looks like the prospect of higher tariffs is already hurting trade.
We will learn more in coming days, with 25% tariffs on the first $34bn of Chinese exports implemented from Friday 6 July (with another $16bn to follow). China’s response and the US reaction to any retaliation (Trump has threatened 10% tariffs on another $200bn of imports) will make the situation clearer.
So far, the overall scale of economic damage still looks relatively small. However, large multinational firms – which are more likely to be listed on the stock exchange – will be worse hit than smaller domestic companies.
On another front, the US is threatening tariffs on European automobile exports. There is some irony here, as Europe imposes a 10% tariff on US automobiles, compared to the 2.5% of the US. However, the US has a 25% tariff on light trucks, which has protected domestic producers and made this the most profitable segment of the market. Europe has promised to retaliate. This fight is developing more slowly than that with China, but it is an important sector – US imports amount to $360bn, which is close to 2% of GDP.
Comparisons with the impact of changes in tariffs in the past are likely to understate the damage from a trade war. This is because the past couple of decades have seen the development of global production networks that mean that any disruption to the supply chain can have magnified effects through a range of products. Perhaps the closest recent example was the Japanese earthquake and tsunami in March 2011 which temporarily sent output and exports down by 16% and had knock-on effects across the region, especially in the automobile sector.
We can assume that a domestic policy response will counter some of the damage from trade friction, but the overall impact is still negative. Trade brings productivity gains through importing goods that other countries make comparatively efficiently, in exchange for those in which you excel.
China is already responding with lower taxes and a cut to reserve requirements in order to free up liquidity in the banking system. This is far from ideal, considering the longer-term objective of controlling the credit bubble, and the probable costs involved, but it is necessary to protect growth in the short term.
The response of central banks in developed markets to a serious escalation of trade friction is unclear. Tariff barriers represent a supply shock that reduces the productive potential of the economy and raises pressure on inflation. The UK is facing a similar dilemma with Brexit and this has made the Bank of England very hesitant to raise interest rates despite low unemployment and a significant inflation overshoot.
In the case of the US, trade friction could force the Fed to pause its tightening cycle, but we would need to see a significant escalation before that is likely, which would be reflected in lower bond yields and equity prices. We continue to expect a rate hike every three months until at least the end of 2019. The US is not a particularly open economy – imports are only about one-sixth of GDP – so it will need a significant escalation to have a material impact on the economic cycle.Disclaimer applicable to recommendation
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