Trade tensions on the rise again
Following the G20 summit, our central case has played out: the US and China missed the 1 July deadline for a trade deal but have agreed to return to negotiations and delayed the next tranche of tariffs. However, our concerns remain as they were before: China’s unwillingness to legally enact substantive changes to its industrial policy and Trump’s belief that tariffs are an effective tool make it hard to see a deal in the short term. The structural and cyclical risk factors remain the same, with risks tilted to the downside regarding an actual deal in 2019.
In the absence of any details thus far, we see the US presidential election campaign as the most important factor driving timing for a deal on the US side in 2020. For the Chinese, Trump’s desire for a 'win' may mean that he is more willing to compromise. However, Trump oscillates between a win being a deal with China or a win being “taking on China”. We think this dynamic loads the relationship with downside risk. Importantly, tariffs remain only one element of the US-China strategic rivalry; any truce is fragile against the backdrop of the much deeper structural conflict between the US and China.
A short-term solution with few details
- Following plenty of positive signalling in the run-up to the G20, the meeting between Trump and Xi resulted in both parties agreeing to return to negotiations and for the US to remove the threat of tariffs in August for the time being. The 25% tariff levied on $200 billion in Chinese imports, which Trump added in recent months, remains in place. In addition, the administration provided some leeway for US companies to sell to Huawei in some circumstances, though the terms are somewhat vague.
- No details were really provided regarding any tangible change in the dynamics between the two countries in this stand-off. Nor were any deadlines set for progress, though these may be released in the coming days. This meeting was intended to de-escalate tension but not provide a roadmap to a genuine solution.
- The Trump administration has said over the weekend that it is in no rush to get a deal and would rather wait to get the right deal; this probably signals a more drawn-out negotiation period than markets would have expected three months ago.
Deeper issues make a deal hard to see in the near term
- Our risk analysis continues to point to mixed incentives for both parties (see below). The deeper structural issues in the US-China relationship mean that the devil truly is in the detail of any deal, with bipartisan support for a tougher line on China empowering Trump to raise tariffs if they cannot iron out their differences. This is very different to political resistance to tariffs against other trade partners such as the EU and Mexico. However, the economic and market pressure continue to provide a potential circuit breaker to further escalation in US-China trade conflict and warrant careful watching.
- It is important to bear in mind that tariffs on goods are just one of the fronts on which this US-China conflict is playing out; deep issues regarding technology, investment and foreign policy that are also ongoing reflect the structural nature of this rivalry.
The election campaign provides a timeline in the absence of any official one
- The coming months will see the Democratic party primaries process heat up, while Trump will also be looking to build out his key campaign messages. By Spring 2020, the candidate on the Democratic side should be clear and Trump will be getting into full campaign mode.
- As part of the re-election campaign, Trump may wish to use a China deal as a 'win' ahead of the election to prove that Trump has followed through on election promises. If so, summer of next year would be an opportune time to announce a deal. The Chinese side will be aware of the political optics and may well benefit from less stringent requirements if Trump just wants a win.
- However, the risk to this is that the Trump campaign has seen “taking on China” as a win with voters in the recent past too. This changes depending on voter sentiment, economic impact and the administration’s temperament – all of which warrant careful monitoring.
- In the meantime, we think the risk of volatility in this relationship will remain high and we maintain a cautious view that negotiations continue but with a deal kicked into the long grass.
Updated scenario assessment
- We have updated our pre-G20 scenarios to now stretch to the end of the year. Very little change has taken place in terms of relative probabilities, though the risk of negotiations falling apart has marginally declined while our central scenario for continued negotiations to year end marginally rose.
- We continue to take a cautious view of the relationship and prospect of a deal in the short term for all of the structural reasons outlined above.
- Beyond the six month view below, we are building a longer-term scenario assessment of the relatively probabilities of a deal in 2020 and beyond. We expect to communicate this research fully in September.
- However, broadly speaking, we remain deeply sceptical of the willingness and ability for the US and China to move away from the strategic rivalry underpinning the trade tensions in the coming years.
- Whether a trade deal is reached or not, we expect the US-China relationship will be fractious for the foreseeable future, particularly if President Trump wins a second term, but even with a Democratic president.
Wide confidence intervals around the scale of economic impacts
- Calibrating the economic impact of tariffs is complicated. First, we need to consider who pays these taxes. They can hit consumers through higher prices, be absorbed into corporate margins, or shift market share towards competitors.
- Alongside these direct effects, we need to think about indirect impacts, as uncertainty weighs on business investment decisions and market stress tightens broader financial conditions. Indeed, these effects can take hold before tariffs are implemented, if corporates fear that their sector will be affected.
- Finally, we need to consider how policy levers might respond to these shocks. Will central banks ease policy? Might governments recycle their tariff revenues into the economy, and if so what multipliers do we expect from these tax/spending measures?
- We have modelled a full-blown trade war in which tariffs are applied to all trade between the US and China (see chart below). This assumes that approximately one-third of tariffs are passed through to consumers, with the residual absorbed into corporate margins and competition. We also assume a full fiscal recycling of tariff revenues, but with relatively low multipliers, and US Federal Reserve policy easing.
- This shock delivers a direct 0.38 ppt and 0.43 ppt drag on US and global GDP growth respectively by 2020. Adding in sentiment effects increases these impacts by around 0.2 pp respectively. The confidence intervals around these estimates are obviously wide. Difference assumptions around incidence, multipliers or sentiment effects can generate both smaller and larger impacts.
- A loose translation of this full trade war scenario to the current status quo with regards to tariffs would suggest a direct impact of around half of this magnitude. However, the indirect sentiment shock may well be larger, given the risk that all US-China trade is drawn into the conflict and residual concerns over autos tariffs and potential levies on Mexico. This would suggest a shock of around 0.3-0.4 pp on global growth from the recent escalation.
What has the story been so far?
- We can cross-check our model output with some simple observations around how the global economy has performed since trade tensions started to build in 2018.
- First, there is increasing evidence that a disproportionate share of tariffs is being paid by US corporates and households. Recent NBER papers have found that “the full incidence of the tariff falls on domestic consumers” and “consumer and producer losses from higher costs of imports were $68.8 billion (0.37% of GDP)”. More simply, the prices of goods imports from China (which are collected before tariffs are applied) have not adjusted lower, suggesting that exporters are not providing discounts to absorb the effect of these levies. Consistent with this, we have seen consumer prices for tariff affected sectors increase noticeably. This implies a more pronounced pass through of tariff measures to US growth and consumer price inflation.
- The impact on the manufacturing sector is also becoming increasingly clear in the US. Both ISM and PMI manufacturing surveys have clearly slowed over recent months. There are likely a number of drivers behind this deterioration, including the subdued global growth backdrop. However, the negative response to the latest flare up in trade over May highlights the important role that trade tensions have played. We have seen the deterioration in sentiment coincide with a clear slowdown in payrolls growth and average hours worked in the manufacturing sector. Additionally, the trend in core capital goods orders has softened over recent quarters. The indirect sentiment channel seems to be clearly weighing on investment, hiring and activity in affected sectors.
- There have been efforts to avoid tariffs. US importers built inventories late last year, ahead of a previous threatened hike. This has distorted the timing of growth, with a potential unwind of these stockpiles expected to provide a drag in coming quarters. Moreover, there has been a substitution of imports from China to other countries not hit by tariffs. This trade diversion will create winners and losers as part of the fallout from this bilateral conflict. From this perspective, China’s loss is Korea, Vietnam and Taiwan’s gain.
- However, there is evidence that the global economy as a whole is losing. Global trade volumes and production growth have clearly slowed alongside the trade shock. Consistent with this, we have seen business sentiment surveys deteriorate significantly, led by a weakening in order books. Many of these surveys report comments from firms highlighting trade uncertainty as one of the major challenges facing businesses. The scale of this deterioration could even suggest that our model underestimates the shock to business sentiment and investment activity from trade uncertainty.
Not so great expectations
- Building trade headwinds are a major, but not exclusive, driver of the downward revisions to our forecasts. In short, our projections no longer incorporate a reacceleration in global growth. Instead, we expect global GDP growth to be flat, and below the post-crisis average, out to 2021. Compared to our previous forecast, we expect global GDP growth to be 0.4 pp lower in 2020 relative to our forecasts just a few months ago (global GDP forecasts below).
- We will need to watch data closely to understand if things are evolving more or less favourably. To help, we have built a global trade monitor and flagged a number of key data points which might tell us if the indirect or direct impact of tariffs has been more or less severe than expected. These include trade volumes, price data at different points of the inflation pipeline, leading indicators of business sentiment and global policy uncertainty measures.
- A more severe escalation in trade tensions between the US and China, a renewed dispute between the US and Mexico, or the imposition of widespread US auto tariffs, would deliver even larger downgrades. Indeed, even when we factor in the likely more supportive monetary policy conditions that this downside scenario would trigger, it seems clear from our empirical work and evidence from the early skirmishes in the trade conflict that growth has been sensitive to these shocks.
What does this tell us about globalisation?
- The US and some other western economies have retreated from leading globalisation, while grapple with the political backlash to the perceived negative distributional and social consequences of globalisation. This includes an economy that is seen to work for the few rather than the many. As a consequence, further liberalisation in the west will come with more strings attached than in the past. Increasing conflicts over trade policy and the use and transfer of technology are a symptom of these deeper fundamental forces.
- As such, the next phase of globalisation will look very different than the last. Slow trade and capital market integration relative to human and informational integration will tilt the relative winners from future globalisation away from ‘super manufacturing trading’ economies and multinationals reliant on global goods value chains and towards more domestically oriented service-based economies and firms. This shift will disadvantage countries with small domestic markets and those still at the beginning of their catch-up growth journeys. We will shortly share our research paper on globalisation – “The future of globalisation in the age of Trump and Xi” – which presents our new in-house index of globalisation and predicts how this will evolve moving forward.
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