After a bad month for markets in February we posited that the selling would likely continue into March, which it did. The S&P fell 4.0%, Eurostoxx fell 2.25% and the FTSE fell 2.42%. Against this oil jumped by 5.35%, gold was up 0.5% and US and UK long bonds rose.
During March, there was a fairly sudden although somewhat foreseeable loss of confidence in certain technology companies such as Facebook and Google. They got into trouble for abusing their positions as holders of customers’ personal data – although everyone knew that their data would not be safe with these companies in the first place. This is a classic “Common Knowledge” example. Other tech stocks such as Tesla also fell. Tesla is highly geared and its technology isn’t up to scratch yet (Tesla’s cruise controls are believed to have led to a number of accidents). These things mean that TSLA is a candidate for bankruptcy.
The risk of higher trading tariffs also weighed heavily on markets. Donald Trump had threatened these tariff increases during his election campaign and has since started to make good on the threat. He has imposed a 25% tariff against Chinese imports of steel and 10% against aluminium . Many fear that this is the beginning of an escalation.
While the above reasons will be offered as explanations for the fall in markets, in fact they were set for a fall in any event. With global growth moderating, QE in the US having come to an end (and in Europe it will end in October, we are given to understand), US interest rates rising since 2016 and with shares having exuberantly priced in various best case outcomes, it was a question of time before markets gave back some of their gains from last year.
Chart 1 – UK Shares now down on a 12 month view and down to their peak 2015 level
Chart 2 – European shares down on 1 year and below their 2015 level
Chart 3 – US Still ahead over 5years and 12 months despite recent falls
Free trade makes people prosperous. Restrictions on trade impoverish them. This much we know.
On the whole the US levies lower tariffs on other countries than they do on it. (See chart 1). Donald Trump used this fact during the election to gain support, arguing that foreign companies have an unfair advantage over American ones.
Chart 4 shows that America’s large trading partners of China and the EU levy more against it than the inverse. (Blue column is taller than red). Each product category of traded good is subject to a separate percentage tariffs, but the chart shows an overall average. As an example the US charges a tariff on the import of European cars of 2% but the EU levies 11% on imports of US cars.
This is why Trump says that the status quo is unfair to US producers which is actually correct. What he didn’t say is that the relative lack of US tariffs is extremely beneficial to US consumers who can make more or less free and undistorted buying choices between (in this example) US and European cars. The opposite is true for European consumers who are deterred from buying US goods. (Anyone in the UK trying to buy goods on Amazon from a US website will have experienced this.)
Chart 4 The net position re tariffs between the US and its main trading partners
(Blue higher-foreign country charges more, Red higher-US charges more)
Chart 4 also shows that there is a small number of small countries where the reverse is true ie they seem to be punished by the US by more than the inverse ie the US levies tariffs on imports from those countries but the countries charge little or nothing by means of countermeasure. Eg according to the chart the US charges taxes on imports from Norway but Norway does not tax imports from the US. I do not know why this is the case.
Has the US always been hostile to trade?
On the contrary, for many years the US has taken an ever friendlier stance towards trade. The effective tariff rate charged by the US against foreign imports has fallen and is now in the region of 2% overall as shown in the chart below. This is a very low figure (again, it is an average across the entire spectrum of traded goods). The rate charged by the US against foreign imports has fallen steadily for nearly 80 years.
Chart 5 showing the History of The Tariff Stance taken by the US
As mentioned, this has been of benefit to the US consumer but it has surely also played a role in the US having a persistent trade deficit ie overall imports exceed overall exports. The deficit is very large in Dollar terms although it has held somewhat steady as a percent of GDP (dotted black line chart 6 below).
Chart 6 – The US runs a persistent deficit in trade with China and the EU
The most recent US rhetoric has been against China who responded to the new steel and aluminium tariffs with a fairly modest counter measure against certain US food products, such as pork. However, the stand out trade imbalance is with Germany. The German surplus with America is large both in absolute numbers and in relation to the size of the overall German economy. It is just a question of time probably before the US – German axis falls into the rhetoric.
Chart 7 – The US has an insatiable demand for German goods
Another way to see this important US-German trade relationship is by looking at the percentage of revenues of German listed DAX 30 companies which relates to sales to the US. On the whole these are high percentages.
Chart 8 – Most listed German companies have a high dependency on sales to the US
Unintended Economic Consequences
While the stated aim of US imposed trade tariffs is to protect US companies from unfair foreigners, one unintended consequence will be higher inflation in America. In fact, the new tariffs against China of 25% on imports of steel and 10% on imports of aluminium are already being felt in the ISM measure of raw material prices which feeds directly into the inflation data.
Chart 9 – Do tariffs lead to higher inflation? If demand is inelastic, they do.
All things equal, higher inflation leads to higher bond yields; holders of bonds require a higher return to compensate them for the erosion in the spending power of their money. US bond yields have been rising since the announcement of the end of QE – made back in 2016. For the time being yields have stopped rising and in fact in February and March US bonds were a safe port in a storm (bond prices rose, bond yields fell) as share markets fell. But if inflation picks up, the yield will rise.
Chart 10 – US 10YR Yields rose since the 2016 low but have recently become a safe place to put money during recent share market turbulence.
Another unintended consequence might be that it becomes harder for the US government to finance its budget deficit (the shortfall between government spending and the taxes it raises). When trade surplus countries such as China and Germany sell their goods to trade deficit countries such as the US the net difference is effectively paid in the buyer’s currency – it’s all he can pay with. In this case German exporting businesses are paid by American customers in Dollars.
The receiver of the Dollars needs to do something with them. Either directly or indirectly through the wonders of the banking system, the Dollars are used to buy Dollar denominated assets and among these are US government bonds. So it is quite normal for the trade surplus countries to become major financiers of the trade deficit countries’ budget deficits ie they end up funding the roads and the schools in the importing country. That is why the biggest foreign holders of US Treasuries are China, Japan and Germany. So a consequence of the importing country trying to reduce the trade surplus country’s surplus (by hindering his exports to you) is to cut some of the funding for government spending in the importing country ie the US.
Conclusion – A Shot in the Arm or a Shot in the Foot for the US?
We have seen from his dealings with N. Korea that Trump knows, likes and is quite good at gamesmanship; he is not afraid to call peoples’ bluff, which people don’t like. Yet it is quite an effective strategy. He talked roughly to N. Korea and made a nuclear threat. Within months, at the behest of China, N.Korea seems to have agreed to stopping its nuclear programme and starting talks with S. Korea. Had Obama achieved this result he would have been feted; he might then even have deserved his Nobel Peace Prize.
So based on form, it is possible that the trade war is another bluff. I do not think that Trump really wants one but in a best case for him, through his actions he might achieve a slightly fairer balance of tariffs as seen from the US perspective and summarised in chart 4.
However, if the trade war were to escalate:
We know that the abolition of tariffs boosts global economic growth. Equally, we know that the reverse – an imposition of tariffs – will curtail global growth and impoverish people.
Some US companies might benefit, but US consumers will be hurt.
Exporting countries and the main exporting companies within those countries will be hurt. This would be most risky for Germany.
The US might generate higher inflation for itself which will lead to higher bond yields. This translates into higher debt payments by the US Treasury to bond holders ie the cost of financing the US budget deficit would rise.
At the same time, the surplus countries would be less able and willing to buy US Treasuries with their diminished surplus of Dollars, thereby probably leading to a further rise in long interest rates (fewer bond buyers all things equal will lead to fall in bond prices/rise in yields).
A trade war will be bad for growth, shares and bonds. But a small increase in tariffs from what really is quite a low base might not make itself too noticeable economically while making a powerful statement politically. It is a high stakes gamble.