US reaction: US hikes tariffs as trade policy outlook worsens
10 May 2019
The US enacted an increase in tariffs on $200bn of Chinese exports today at 12.01 (EST).
The tariff increase reflected the deterioration in ongoing negotiations. However, Chinese Vice Premier Liu He remains in Washington to continue to negotiate a broader deal today and President Trump suggested he may speak directly with President Xi.
The outlook for trade policy is highly uncertain from here. Ongoing negotiations provide hopes of reaching a settlement that would render the recent trade increases temporary. However, with both sides discussing retaliation and further escalation, such optimism could fade quickly.
US financial market reaction has been muted so far. Increased tariffs risk lowering US GDP growth by 0.25-0.5ppt over the coming two years. Such an effect could be offset by easier Federal Reserve policy. Nevertheless, already facing a number of internal headwinds, permanent tariff increases pose a further threat of material deceleration in the US economy.
Chinese financial market reaction has been sharper. Current tariffs threaten reducing Chinese GDP growth by around 0.3ppt. Associated policy easing would likely see China able to maintain 2019 GDP growth above 6%. However, broader tariff increases could reduce growth by up to 1.5ppt, and would not be broadly offset with even significant policy easing.
The US lifted tariffs on $200bn of Chinese goods, from approximately 5,700 product ranges, to 25% from 10% on Friday at 12.01am (EST) – a move forewarned by President Trump on Sunday. The tariffs took effect immediately but apply only to goods shipped after 10 May. The increase in tariffs reflects a relatively swift reversal of trade negotiations that have been underway for several months and had been largely described as making “progress”. The reversal appears to have been precipitated by China attempting to redraft areas of previously agreed text in the trade agreement, specifically focusing on imbedding new trade pact agreements in Chinese Law. Meanwhile in a letter sent from Chinese Premier Xi to President Trump, Xi discussed “equality”, suggesting that China believed the trade deal was increasingly unbalanced in its benefits.
The outlook for trade policy is highly uncertain from here. While announced, US tariff increases will not bite for another couple of weeks. Meanwhile, negotiations continue. Liu He Vice Premier is currently in Washington meeting with Trade Representative Lighthizer and Treasury Secretary Mnuchin. Yesterday, saw 90 minutes of negotiations followed by a working dinner, but “little progress” was made. Discussions are due to continue today. Moreover, President Trump referred to a “beautiful letter” from Premier Xi, and suggested that he may speak directly to the Chinese leader by phone. Trump continues to suggest that a deal, even this week, is possible. And on balance, we continue of the view that some form of agreement is likely over the coming weeks, leaving these latest tariffs as temporary.
However, China immediately announced that it would retaliate, although has so far withheld from releasing any detailed measures. Given much smaller US exports to China, Beijing is constrained in responding in tit-for-tat to the tariff increases. While a partially-matching tariff hike looks likely, China’s $1.1trn holding of Treasury bonds, the RMB exchange rate, and measures to impact China-based US companies are other channels that could be used to retaliate to increased US tariffs. That said, pursuing such retaliation could backfire on China and escalate the level of confrontation, making further trade negotiations difficult, if not impossible. Moreover, President Trump is also considering tariffs on the remaining $325bn of Chinese goods that the US imports, something that Chinese retaliation could make more likely. Such a move would mark a serious escalation of a deteriorating situation, although one that would only take place over the coming months.
A lasting agreement between China and the US has always appeared a bit of a stretch. The US attempts to address structural issues of state subsidy, intellectual property violations, and market access in these negotiations were always likely to prove difficult. Nevertheless, we had assumed that an extended truce, rather than a lasting peace was possible – and may well still be what is delivered over the coming weeks. However, the risk of a material escalation in the US-China trade war has raised the prospect of a more damaging phase for the global economy. Indeed, it appears that the perceived progress the two countries were making towards avoiding a trade war, had resulted in unwinding the material tightening in financial conditions at the end of last year, and had seen economic activity in both the US and China improve over the first few months of 2019, may have contributed to the recent impasse. Emboldened by the more supportive economic progress on both sides of the Pacific, the independent negotiators may have firmed their negotiating positions.
The immediate impact on financial markets has been obvious, if relatively subdued. Since President Trump’s tweets on the possibility of tariff increases on Sunday, the S&P 500 index has lost 2.5%, 10-year Treasury yields are down 9bps and the US dollar has fallen back by 0.1%. We suspect that this reaction reflects ongoing hopes that these tariffs will prove temporary and a stepping stone towards a broader trade deal – in keeping with our own outlook.
However, with the risks of increased tariffs becoming not only persistent, but escalating further, we again reconsider the impact of these on the US economy. Last year, we estimated the impact of a change in tariffs on the US and suggested that the impact would be felt through three separate channels – the direct effect of trade, the indirect effect of tighter financial conditions, and the resultant effect of weaker global demand. We estimated that taken alone an increase in tariffs to 25% on $200bn of China products would reduce the US GDP growth outlook by around 0.25% over two years. An escalation to cover all Chinese goods would be approximately double that effect at around 0.5%. However, given that we considered the bulk of that effect to come from a tightening in financial conditions we highlight the uncertainty around such a forecast. This appears particularly relevant with the sharp tightening in financial conditions seen during Q4 of last year and subsequent reversal so far this year. These swings in financial conditions reflected more than just reactions to trade policy, but market reaction to rising protectionism and the perceived impact on the global economy was a significant factor.
Also, as was seen last year, this deterioration in outlook may also have been mitigated by domestic monetary policy action. Without the sharp tightening in financial conditions last year, we had expected the Fed to tighten policy another three times over the coming years. We currently expect no change in Fed policy this year and if trade shocks are avoided, see US economic activity strong enough to warrant further tightening next. However, if tariffs produce a renewed negative growth shock to the US economy (of around 0.25-0.5% over two years), then this would likely be sufficient for the Federal Reserve to ease policy as it tries to maintain US economic growth at a sufficient pace to lift US inflation back to 2% (and above) on a sustained basis. An escalation in trade wars may thus justify the cut in Fed policy rates that markets have been predicting in recent months. Moreover, a growing sense of a ‘Powell-put’ may also have emboldened the White House to follow through with economically damaging trade policy. However, given the likely internal headwinds that the US faces over the coming year this seems a particularly dangerous strategy, relying on a particular fleet of foot and well-judged monetary policy to offset growing risks of a material slowdown in the economy.
Chinese financial markets have seen a sharper reaction. The Shanghai Composite Index is down 4% since President Trump suggested tariffs, but a broader 10% since mid-April where concerns about trade policy first arose. Moreover, this is after a 3% rebound in stocks overnight, thought to be at least in part reflecting active buying of China state-backed funds to support the equity market overnight. Meanwhile the yuan has depreciated by around 1.5% to the US dollar over the past week.
If sustained, the escalation of tariffs would have tangible economic impacts on China. Our previous analysis suggested that the additional tariffs could shave 0.3ppt off China’s GDP growth if maintained over a twelve-month period. This could rise to 1.5ppt if coverage were extended to all China exports to the US. In both cases, we would expect Beijing to step up policy easing to mitigate broader economic damage. Monday’s targeted Reserve Requirement Ratio (RRR) cut appears a harbinger of this. In a worst-case scenario, the PBoC may have to cut RRR a few more times, lower interest rates, and relax mortgage and shadow-banking policies. Fiscal stimulus is also likely to be dialled up, with the government accelerating the remaining tax/fee cuts promised by the NPC and increasing infrastructure investment. If implemented effectively, stimulus measures would likely mitigate most of the effect of the recent increase in tariffs and we would expect Chinese GDP growth to still make 6% this year. However, further escalation of tariffs to include the remaining $325bn of Chinese exports would likely make defending the 6% growth target for this year a real challenge, even with significant additional policy supports.
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Notes to Editors
All data sourced by AXA IM as at 10 May 2019.