This is not a trade war...yet

Investors beware: by any reasonable definition, we are not yet in a ‘trade war’ but the risk of one is rising sharply.

As recently as 23 January, President Donald Trump declared that there won’t be a trade war after he imposed tariffs on washing machines and solar panels imported from China and South Korea. And yet, on 2 March, following his announcement of stiff US tariffs on steel and aluminium imports, he appeared to be relishing the prospect, tweeting that:

“Trade wars are good, and easy to win”.

Even putting to one side the very dubious claims that trade wars are good and easy to win, this still begs two questions, ie:

  • What actually constitutes a ‘trade war’? and,
  • Are we in one now or, if not, is that where we are heading?
Not there yet…

Writing on 2 March in Fortune, Grace Donnelly defined a ‘trade war’ as follows:

“A trade war is when a country imposes tariffs or other barriers on imported products, prompting other countries to retaliate by implementing similar taxes or penalties”.

Personally, I think that this is overly simplistic — which, to be fair to her, Ms Donnelly implicitly concedes in the commentary which follows in her article, in particular by noting (rightly, in my view) that:

“The last trade war was in the 1930s, and intensified the effects of the Great Depression, according to economists and trade experts”.

By general consensus, ‘war’ was effectively declared in 1930 by the passing of the Smoot Hawley Tariff Act by the US Congress, raising border tariffs on over 20,000 products. Even though I would argue that it does not requires something so far-reaching to amount to a ‘trade war’, we are clearly a very long way short of similar circumstances today.

Nevertheless, in the unlikely absence of escalation from where we are today (which is the bottom line to this article), we are going to hear the term ‘trade war’ used repeatedly in the coming weeks and months — and, as often as not in all probability, without too much thought being given to what exactly we would need to see, as opposed to heightened trade tensions and frictions. (Indeed, I recognise that I myself am guilty in indulging in hyperbole on this score from time to time, for example in my recent article ‘Trade: The “phoney war” is over’!)

For the past week or so, therefore, I have been testing out the following on my client base to try to come up with useful yardstick by which investors (and others) may be able to assess just how serious the situation is:

  • Trade frictions arise from policy actions which affect an individual sector with substantive consequences, negative and positive, for firms operating within that sector (including on their stock valuation) but with no significant impact on the GDP of the individual national economies involved;
  • A trade war occurs when such policy actions reach the point where there is a significant, generally negative, impact on the GDP of those nations which are involved.

Warnings from, among others, the IMF that Mr Trump’s announcement on steel and aluminium last week could trigger such a scenario notwithstanding, we are clearly not, by my definition, yet in a trade war.

…but we are on the brink

Descending into what I would believe would constitute a trade war does not appear to me to be inevitable. But the auspices are not especially encouraging. Consider.

  • Mr Trump is, at heart, an economic nationalist. It was as long ago as mid-2016 that I first wrote about Trump the protectionist in a research note for one of my clients. His record of protectionist rhetoric stretches all the way back to the mid-1980s when he spoke out strongly against Nafta. Since then, all the indications have been that he genuinely believes that ‘free trade’, as it manifests itself in practice today, has not been and is not in the best interests of the US; that bilateral trade deficits are largely, if not purely, the result of other trading nations ‘cheating’ America; and that tariffs on imported goods will restore manufacturing jobs to America. Furthermore, he has surrounded himself with like-minded economic nationalists — Robert Lighthizer (pictured), Wilbur Ross, Stephen Miller, Peter Navarro — who (and despite the departure of Stephen Bannon from the White House) seem now firmly to have the upper hand.
  • The time is now 'right'. The fact that nothing really bad happened on trade during Mr Trump’s first year in office can be accounted for by two factors, in my opinion. First, his views on trade are not consistent with Republican ‘mainstream’ thinking (as is underlined by the fact that there is more Democrat support in Congress for the measures he announced last week than there is Republican); needing Republican support for tax reform, it was always highly likely, as I argued last year, that he would deal with that before turning to trade. Second, Mr Trump in office has discovered that trade is much more complicated than Candidate Trump had imagined — as is underlined by the reaction of various business groups to the steel and aluminium tariffs. This allowed the likes of Gary Cohn and Steve Mnuchin to push back with at least some success against the economic nationalists.
  • Mr Trump is nothing if not mercurial but…. It is possible that he may still pull back somewhat from the sweeping announcement he made last week. For example, the pro-trade ‘lobby’ in the Administration coupled with senior voices on the national security side (James Mattis, HR McMaster) may yet persuade the President to carve out exemptions for close US allies which include six of the top ten steel exporters to the US (ie: Canada, South Korea, Mexico, Japan, Germany and Taiwan). However, national security concerns seemed to count for very little when Mr Trump slammed South Korea with tariffs on washing machines and solar panels last month. Furthermore, the manner and wording of Mr Trump’s announcement last week (not to mention his subsequent tweeting) strongly suggest that he has no intention whatsoever of following in the footsteps of George W Bush who imposed tariffs on steel in 2002 only to annul them the following year when it became clear that they were not WTO-compliant (more on which below) and were seemingly doing more harm to the US economy than good.
  • The WTO is unlikely to defuse the situation. It is certainly the case that economies hit by the steel and aluminium tariffs will take the US to the WTO. However, its dispute settlement procedure takes months to come up with a ruling at the best of times. Furthermore, given the unprecedented nature of the US’s invoking of the national security provision in the GATT as justification for these tariffs, any decision which emerges is sure to go to appeal (and it is possible, if unlikely in my view, that the measures could be ruled WTO-compliant). But, unless there is a major change of heart by Washington, which is blocking the appointment of replacement judges, there will not be a functioning appellate body by end-September. And even if the dispute settlement mechanism is fully functioning, there is a real — and, in my view, entirely justified — sense that Mr Trump would, at best, simply ignore any ruling which went against the US and, at worst, could conceivably look to withdraw the US from the Organisation (which he may or may not be able to do constitutionally — see my 2 September article).
  • The EU will almost certainly retaliate. EU ministers will meet on 5 March to consider possible counter-measures which could come into force 90 days after steel and aluminium tariffs are put in place. They will most likely target, in the first instance sectors which enjoy a powerful lobby in Washington (notably agriculture), electorally sensitive states (eg Florida, Wisconsin) and iconic American brands (eg Harley-Davidson, Levy) in order to try to maximise pressure on the President to back off. Such measures will almost certainly be approved, albeit in a manner which is proportionate to the European Commission’s estimate of the probable economic cost of the US tariffs to the EU (ie around USD3.5bn). However, it is already clear from his threat against auto imports from Europe that, far from folding, Mr Trump would see this as an escalation demanding ‘tit-for-tat’ measures by Washington.
  • The EU will not be alone. Brazil, Canada, China, Japan and Mexico are also reportedly considering retaliatory measures. Indeed, China — for all the relatively restrained nature of its rhetoric following Mr Trump’s announcement, not to mention top economic adviser Liu He’s visit to Washington last week to try to defuse tensions — had already taken steps by imposing restrictions on imports of styrene from the US and launching an investigation into US sorghum. Despite China’s clear desire to avoid a trade war, more will follow either formally (eg sanitary and phytosanitary measures against farm products) or informally (eg encouraging a consumer boycott of US autos) or both.
  • There is more to come from the US in any case. Whether or not we get a whole series of tit-for-tat measures rooted in the steel and aluminium case, we can be very sure that the US will take more trade-related steps in the coming weeks. Perhaps most notably, the USTR’s Section 301 investigation into conditions imposed by China on foreign firms looking to access its market is expected to reach its conclusions shortly. If, as is widely expected, China is declared guilty as charged Mr Lighthizer has already made it clear that he will recommend unilateral measures to try to pressure China into changing its ways. This is likely to mean more tariffs. Then there is the Nafta renegotiation, currently in its seventh round with reportedly major hurdles remaining in the way of agreement, progress on which is not likely to be helped by the imposition of steel tariffs which hit both Canada and Mexico; a breakdown in the process could well spur Mr Trump into more unilateral action. Furthermore, the US Department of Commerce has multiple additional investigations under way (eg on alleged dumping of biodiesel in the US market by Argentina and Indonesia) which may not enjoy the high profile of steel and aluminium but which, at least cumulatively, stand to add significantly to trade frictions globally.
  • Pressure works in two ways. I firmly believe that Mr Trump’s views on trade are not only (largely) misguided but also that, if he follows through to the full, he will be acting in a way which is ultimately counterproductive not only to his economic objectives but also to his prospects for getting reelected in 2020. The point here is the obvious one, ie a trade war threatens to bring with it inflation, the biggest impact of which will be felt largely by the very people who constitute Mr Trump’s ‘base’. But — and this is a big ‘but’ — as my use of the word ‘ultimately’ indicates, it is likely to take some time before this becomes clearly apparent to the point where reelection considerations combine with (no doubt increasing) pressure from business and mainstream Republicans may force him to back off. And in the meantime another sort of pressure is likely to weigh more heavily. There seems to be to be little doubt that what certainly appeared to be an otherwise unnecessarily rushed announcement on tariffs last week was precipitated by an unusually bad few days in terms of news flow even by this Administration’s ‘normal’ standards. This rather underlines what many see as Mr Trump’s propensity when under pressure to seek distractions and shore up his approval ratings by throwing ‘red meat’ to his base. What is now widely perceived (even by Trump allies) as the general chaos, combined the Mueller investigation, threatens to ratchet up such pressure still further. This, in turn, could easily drive Mr Trump to even more trade-related measures than might otherwise be the case.
Markets will move

We have already seen that such actions have the ability to move equity markets. So far, this has been entirely manageable. But escalating trade tensions could exacerbate market febrility considerably, especially if they are coupled with uncertainty over where policymakers are heading. Add to this the possibility that, even if Mr Ross is correct in claiming that the impact of the steel and aluminium tariffs per se is likely to be modest as far as consumer prices in the US are concerned, successive waves of tit-for-tat measures could fuel inflation sufficiently to have the Federal Reserve considering additional rate hikes.

Against this backdrop, I stand firmly by the view expressed in my Outlook for this year that trade protectionism constitutes the fattest political tail risk to the benign near-consensus scenario of the ‘Goldilocks’ economy persisting through until 2019. I remain with that consensus for now; but the risks posed by Mr Trump’s trade agenda are certainly increasing.

Alastair Newton