Protectionist state of play
The trade paradigm is shifting and markets are being forced to play catch-up. While the actual measures implemented so far are relatively contained and represent more of a micro than a macro risk, recent proposals by Trump pose a more significant economic risk. Up to an additional $400bn in tariffs on China, and a 25% tariff on global car and auto part imports are both reportedly under consideration. Beyond the risk to growth, the global nature of Trump’s protectionist policies (see Chart 1) threatens to upset the global political order and force a shift in supply chains, often with unintended consequences. One such consequence is the recent announcement that China and the European Union agreed to launch a group to update global trade rules to address technology policy and subsidies, and to preserve support for international trade. Notably these talks exclude the US. Although the EU has many of the same trade, investment, and business environment concerns as the US with regards to China, the proposed talks are further evidence of the rest of the world hedging against US uncertainty. Japan leading to salvage TPP; the EU pursuing trade agreements with Japan, ASEAN, Mexico, and Australia; and now trade talks between China and the EU are all indications that globalisation might not be dead, but the rest of the world is certainly looking to leave the US behind.
The economic and financial market impacts depend on whether the Trump administration pursues its more damaging proposals. With US imports valued at over $55bn facing tariffs, and retaliation from China, Canada, EU, Mexico, Turkey and India valued at over $50bn of total imports, certain sectors will be impacted but the overall growth impact will be negligible. The key to watch for whether Washington pursues the more damaging path will be domestic political pressures in an important election year. News of Harley Davidson moving production overseas has so far received mixed reviews. As tariffs begin to impact prices and supply chains reorient, the true costs will become clearer. However, even without a full-blown trade war, increased uncertainty is already affecting investment flows and roiling global markets. While escalation is hard to predict, the current level of political discord might make it difficult to find an off-ramp.
Raising the stakes
We have clearly seen trade tensions build this year (see Chart 2). The first shot was fired in January, with the US announcing tariffs on washing machines and solar panels. This was followed by levies on steel and aluminium, controversially justified on national security grounds after a Section 232 investigation. Temporary exemptions from these measures for NAFTA partners and the EU blunted their initial impact and hinted at wheeling and dealing behind the scenes. However, these exemptions have now expired. Meanwhile, China has been singled out for special attention after a Section 301 investigation found it guilty of intellectual property theft. Following public consultation, the administration is set to impose tariffs of 25% on $34bn of imported Chinese goods on July 6, with a further $16bn likely to follow in August. These tariffs will overwhelmingly fall upon intermediate and capital goods, many of which are derived through supply-chains from non-Chinese based multinationals (including some US names). The decision to go ahead with tariffs follows a back-and-forth, during which it looked like a deal to avert these measures was close. Instead, China is expected to reciprocate in like-for-like terms with its own penalties on US exports.
While the scale of measures announced thus far accounts for only a small portion of US imports, talk of further escalation is alarming. The President last week warned that the US would respond to any Chinese tariffs by introducing levies on a further $200bn of imported goods from China, albeit at a lower 10% rate. This would bring a much wider group of products under the tariff umbrella, including final consumer goods. It would also likely prompt more retaliation from China. Some of this would come in the form of reciprocal tariffs, which would be felt most in agricultural goods, autos, airplanes and technology, considering the narrow composition of the US export profile with China (see Chart 3). However, given that China only imports around $150bn in goods from the US it would need to turn to non-tariff measures, where it has significant ammunition. These could range from fewer tourists and students travelling to the US, to restrictions on the ability of US multinational to operate in China’s lucrative market, to product boycotts. China is not alone in the spotlight. The President has also ordered another Section 232 investigation into the auto sector, which could pave the way for tariffs on auto and automotive-part imports. The Peterson Institute has estimated that, if implemented across all partners, this would hit production in the US sector by 1.5% over the first three years. When adding in reciprocal action by partners, this drop deepens to 4%.
Certainly it is difficult at present to predict if these threats will be followed through. Indeed, fears over trade tensions have waxed and waned through this year, as signs of breakthrough have rapidly deteriorated into reciprocal threats of further protectionist measures. While the path has been bumpy, the direction of travel has clearly been towards more tariff and non-tariff barriers to trade. Moreover, there are few signs that this tension has peaked, and we could well see further short-term moves along this protectionist path in the current climate.
Stuck in the middle with EU
The recent escalation in trade tensions should have a relatively small direct impact on the UK economy. Many of the goods and sectors that have been targeted by the US administration for protectionist measures are not especially important to the UK. For example, UK exports of aluminium and steel to the US account for about 0.3% of exports, less than 0.1% of GDP. However, given that the US is the UK’s largest single export market, a more sustained shift towards US protectionism, perhaps leading to an outright trade war between the EU and the US, would be very damaging to the UK (see chart 4). Moreover, even if the UK’s direct exposure to increasing tariffs is currently quite small, there are various indirect effects that could start to weigh on activity. For example, a decline in business and investor confidence associated with fears of a trade war could cause financial conditions to tighten and hold back investment. Elevated uncertainty about the UK’s future relationship with the EU is already crimping business investment, so the UK seems particularly vulnerable to a further shock to confidence.
Indeed, it is the UK’s relationship with the EU that will probably prove far more significant to its future trading prospects. Following the referendum result, sterling depreciated sharply, helping to improve the competitiveness of exports and the profitability of exporting businesses. Along with robust external demand, this helped boost export growth and improve the current account (see chart 5). However, this period represented a ‘sweet spot’ for UK exporters, who were able to benefit from weaker sterling, while not yet experiencing the loss of access to EU markets associated with Brexit (the expectation of which caused sterling’s depreciation). The UK cannot enjoy this position forever. Eventually, it needs to crystallise a new trading relationship, at which point it will either lose some access, or sterling will appreciate to reflect a deal with more market access than is currently priced. Our base case is that the UK will agree a free-trade agreement with an all-UK customs union and some regulatory devolution to Northern Ireland. While this position would solve the Irish border issue, it involves less access and openness than full single market membership, which we expect to represent a drag on long-run growth.
Elsewhere, the Bank of England voted 6-3 to keep policy on hold in June. The decision was widely anticipated, but the vote was closer than expected, with the Bank’s chief economist Andrew Haldane joining perennial hawks Ian McCafferty and Michael Saunders in voting for a hike. The tone of the statement was relatively optimistic about the outlook for the economy. The weakness of manufacturing in April was dismissed, with the MPC focusing on the bounce-back in retail sales and strong employment growth instead. This upbeat tone and hawkish surprise in the voting composition is consistent with our expectation of an increase in the Bank rate in August. The other interesting development was that the Bank updated its guidance on the process of running down its stock of asset purchases. Previously the Bank had said it would wait until the Bank rate was at least 2% before starting to unwind purchases. However, because it now believes the lower bound is lower, the MPC has reduced this threshold to 1.5%.
Caught in the crossfire
Europe and the US are currently engaged in a trade spat, rather than a trade war, but the risk of escalation is clear. Following an initial reprieve, US tariffs of 25% on steel and 10% on aluminium imported from the European Union came into force from 1 June. EU retaliatory tariffs of between 10% and 50% on a broad range of US imports came into force on 22 June. For now, these tariffs are on a sufficiently small number of traded goods, by value, that they are unlikely to have a meaningful macroeconomic impact. EU steel and aluminium exports to the US are equivalent to just 0.05% of EU GDP (0.06% of GDP for Germany specifically). Instead, the primary impact of tariff measures to date has been on confidence, rather than trade volumes themselves. The European Commission, Sentix and ZEW measures of confidence in the Eurozone have been turning lower since the start of the year, albeit they remain at elevated levels. But the forward-looking elements of these surveys have been plummeting particularly rapidly, partly driven by trade concerns. The predictive power of these surveys is mixed, and we don’t expect a further worsening in Eurozone growth from the slowdown already experienced in Q1. However, they clearly signal that consumers, businesses and investors are worried about trade developments.
A more significant macroeconomic impact would come from a further escalation in tariffs between Europe and the US. Using figures for the Eurozone specifically, some 14% of total exports, worth 2.7% of Eurozone GDP, go to the US. Germany alone accounts for around one-third of those exports, totalling some 3.4% of GDP (see Chart 6). The shares of value-add sent to the US are smaller, but only by a little. Moreover, specific sectors are disproportionately represented in European exports to the US. Europe runs large trade surpluses with the US in automobiles, industrial machinery and equipment, and medical and pharmaceutical products. President Trump has previously singled out German auto exports to the US, and the sector could well find itself in the firing line during any future round of tariffs. Auto tariffs would represent a significant escalation and would entail a costly reorientation of some production. Additionally, retalitation in this scenario is hard to predict.
Further escalation would come at a bad time for the Eurozone, which is seeing weaker net trade volumes for reasons other than creeping protectionism. Total Eurozone export volumes declined 0.4% year-on year in the first quarter, only the second quarterly decline since the broad-based weakening in global trade during the financial crisis. Indeed, net trade made a negative contribution to Eurozone GDP growth in Q1, and the goods-only trade numbers for April showed the Eurozone trade surplus contracting further. Moreover, the Eurozone manufacturing export orders PMI has dropped from above 60 at the end of last year, to 52.5 in June, signalling more weakness in export volumes ahead (see Chart 7). All this primarily reflects the lagged impact of earlier euro appreciation, but there has clearly been something of a slowdown in global trade volumes that, if exacerbated by snowballing protectionism, would harm the relatively open economies of the Eurozone. Growth should remain steady but weaker sentiment, rising uncertainty, and slowing global trade all pose risks.
There has been a great deal of debate about the viability of developed Asia’s export-led growth model. For some, the post-financial-crisis slowdown in global trade relative to economic activity highlighted a structural shift, with trade elasticity weaker due to a petering out of the forces of globalisation and a rebalancing to domestic demand, particularly in the emerging world. For others, the rebound in trade in 2017 driven by a revival in corporate investment, particularly in the technology sector, proved that the slowdown was temporary – with the GFC hangover behind us. The shift in US trade rhetoric, and increasingly actions, on trade adds to an already confused picture. The market may fear the worst but can Asia’s trading nations shrug off the recent setbacks or are they the death knell for export-led growth?
The first thing to point out is that the stakes are high. Growth in the region’s major economies has been highly sensitive to global trade volumes since the financial crisis, with Japan and Korea seeing the greatest correlation (see Chart 8). A disruptive period of tariff adjustment could certainly affect the international competitiveness of the region’s economies. Furthermore, higher import prices are likely to reduce real disposable income and weigh on private consumption. So, is such a scenario likely? Let us consider the impact of the measures proposed to date. The initial proposals for $50 billion in US tariffs levied on over a thousand export items from China, and a retaliatory $50 billion in tariffs on US imports to China, is likely to have a direct effect on developed Asian economies, primarily through corporate subsidiaries’ exports in electrical machinery and information communications equipment from China to North America and through foodstuffs from China to the US. However, even if this amount was increased substantially, with an additional $200 billion in tariffs from both sides, the magnitude of impact would be relatively modest. More direct US threats of tariffs on regional exports are more difficult to ignore; however, again the impact appears modest. For example, Japanese exports to the US stand at ¥213.4 billion and ¥25 billion for iron and steel and aluminium products respectively. Tariffs of 25% and 10% respectively mean that the magnitude of the additional burden would be just ¥53.3 billion and ¥2.5 billion respectively. The picture turns more alarming if the prospect of a 25% US tariff on autos materialises, with an additional burden of ¥1.4 trillion, given Japanese auto exports to the US total ¥6.6.
So what should we expect if the US Department of Commerce’s initial Section 232 investigations result in meaningful tariffs being imposed on the sector? If the additional cost is fully passed on to the consumer, it could result in a material decline in demand, with estimates pointing to a 20% drop based on historical price elasticity. In reality, the automakers are likely to absorb some of the cost, with the appetite here likely to be significantly higher if President Trump’s prospects of a second term were meaningfully lower. Perhaps the easiest solution is already long in the tooth. Judging by the steady rise of the overseas production ratio, Japanese firms have already been increasingly relocating production to the US (see Chart 9) to avoid being caught in the trade crossfire.
One round… or many?
We continue to go in circles on trade policy. Following the initial 301 tariff threat, ZTE sanctions, and a reported ‘truce’, tariffs are again back on the table. And not just any tariffs, $450 billion worth of potential tariffs. So once again, the question vexing markets is whether or not this is brinksmanship and can be negotiated, or part of a longer-term strategy aimed at restructuring the US/China economic relationship. The answer, while crucial, is not clear. If brinkmanship, a Chinese offer to buy more US products could likely resolve the tariff problem (even if investment restrictions are expected to stay). However, if part of a broader plan to hurt China by reducing their competitiveness and redirecting supply chains while accepting the costs to the US economy, then tariffs will proceed. I suspect the Washington bureaucracy has shifted and is prepared to take a more confrontational strategic approach to the China relationship, especially now that the business community has also shifted towards a more hawkish stance advocating for more pressure on unfair Chinese policies. Trump himself, however, remains the question mark and, in trade matters, the President matters the most. Unlike broader foreign policy which can be influenced and shaped by Congress and civil servants, on trade policy, after years of ceding authority to the White House, Congress has little ability to influence the outcome. So, what Trump wants ultimately matters.
Assuming tariffs are implemented, how could the situation develop? There are two broad potential outcomes – a one-round fight or multiple rounds. Most trade conflicts have been ‘one round’ i.e. tariffs are implemented, retaliatory tariffs are implemented, and then both countries negotiate an outcome. This conflict could follow that path -- China does not want tariffs adding stress to an economy already weakening, and the US does not want consumer distress in an important election year. But, if both leaders assume they have the upper hand, and due to domestic pressures, the situation could quickly escalate. If one round, the economic impact would be minimal: $50bn in tariffs on China is a drop in the bucket compared to the size of China’s economy (see chart 10). However, if the US escalates with a 10% tariff on an additional $200-$400 bn of imports, 90% of China’s total exports of goods to the U.S. would be affected, likely resulting in significant economic disruption. How would China respond? Three broad options stand out: a) restrict US business activity in China (see Chart 11); b) depreciate the currency; and c) sell US Treasuries. We deem options A and/or B as the most likely.
China’s response through the trade channel is limited, forcing the use of other measures to retaliate. Owing to the fact that US businesses derive a significant portion of either overall sales or sales growth from China, we deem it likely that China will retaliate either formally or informally against US corporates. While the economic impact on the US is unclear, revenue disruption and resulting equity volatility could achieve similar negotiating leverage. The next effective option would be currency depreciation. A 10% depreciation could offset the additional tariffs at a 10% rate, although not without significant risks, including exacerbating outflows. There are no costless options, but hopefully we don’t reach that point.