There are many in financial markets who believe that trade wars can bring down the global economy. We have a more sanguine view. While concerning from a global macro perspective, the size of tariffs that have been announced and proposed by both the U.S. and China are relatively small as a proportion of the overall economy.
Chinese exports to the U.S. are a small and declining share of China’s GDP, about half the proportion of ten years ago. We have yet to see so-called ‘second order’ effects from the implementation of tariffs, by which we mean a negative impact on business and consumer confidence and, in turn, business and consumer spending. Tariffs will have a modest negative impact on U.S. growth and a modest upward impact on U.S. inflation. Considering the strong performance of the U.S. economy, the overall impact should be relatively small.
Equity markets imply that a trade war would have more of a negative impact on China than the U.S. and that is evidenced by the fact that Chinese companies with a high proportion of their sales to the U.S. have significantly underperformed U.S. firms who have a high proportion of their sales to China. While the conclusion of a trade deal between the two countries is far from certain, we think that calmer heads will prevail, not least because a trade deal in the medium term is in the best interests of both the U.S. and China.
Chinese exports to the U.S. rose strongly after it joined the World Trade Organisation in late 2001 but have been falling since 2006 and are now less than 4% of GDP. In terms of value added, the share is even lower as these data include imported components.
Following the Trump tariffs, Chinese exports to the U.S. are set to fall markedly particularly if, as we expect, the rate is increased to 25% on January 1, 2019. But the result is likely to be a diversion of the source of U.S. imports from China to other countries. South Korea or Japan could provide more high-tech goods while labor-intensive products could be sourced from Vietnam or Mexico. In addition, Chinese exports outside the U.S. would increase. There would be some job creation in the U.S. but this is likely to be limited and offset by lower production by U.S. companies facing higher input costs due to the tariffs.
The recent trade deal between the U.S., Canada and Mexico supports our view that the Trump administration does not want a full-scale trade war but is focusing on China.
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