A throwback to the dark ages

President Trump has tweeted that he loves collecting “BIG TARIFFS”. In a telephone interview he defended the use of tariffs as a “beautiful thing” and vowed China would “never catch” the US economy in terms of size. At least he can’t be accused of equivocating.

Let’s take his last statement first. The US economy (nominal GDP) currently amounts to around US$21 trillion whilst China’s is around US$13.5 trillion. It’s a big gap but the key is the rate of China’s catch-up. If China maintains a growth advantage of 3% or more over the US it will match it in terms of the size of GDP in around 15-16 years. Even if it takes 20 or more years it is an inevitability. China is not without serious issues – rapidly increasing levels of debt and its static to declining workforce to name but two – but is benefiting from classic emerging market productivity gains applied to a massive population base whilst the US is a mature economy with modest rates of productivity growth (in keeping with the rest of the advanced world).

The chart below examines the share of world GDP taken by the “big 3” since 1960 – the US, China and Japan. The Chinese spurt commenced around the time it joined the World Trade Organisation (2001) whilst Japan and the US have experienced rapid relative decline over the same period (albeit more pronounced in the case of Japan).

The US, China (ex-HK and Macau) & Japan in the world economy

Share of global GDP at market exchange rates

Source: Thomson Reuters Datastream 

Tariffs are a blunt and imprecise economic implement being utilised, in this case, to fight a political battle. They result in a subsidy from the efficient to the inefficient and distort the allocation of capital. They raise costs and lower growth – everywhere. All of this is known. The world has experienced tariffs in one form or another for centuries, so the consequences are not a matter of wild conjecture. The expansion in the global protectionist mood is a throwback to the economic dark ages.

The OECD recently endeavoured to put some numbers on the potential impact of the China-US trade spat. The first round of tariffs in 2018 were estimated to cut the level of output in the US and China by around 0.2% - 0.3% with world trade reduced by around 0.4%. US consumer prices were forecast to rise by around 0.2% in 2020 and 2021 (above the baseline forecast). The second round of tariffs in May this year potentially reduce GDP in the US and China by an additional 0.2% - 0.3% on average by 2021 and 2022 with US consumer prices pushed up by an additional 0.3% in 2020.

If the US proceeds with its threat to impose a 25% tariff on all imports from China the OECD estimates that global trade would be close to 1% below baseline by 2021 with import volumes in the US and China down by around 2%. Output would decline by around 0.6% relative to baseline in the US and 0.8% in China. “Close trading partners would also start to be adversely affected, as demand contracts in two major export markets ... further uncertainty about trade policies, and a growing concern that new restrictions might be applied on a much wider range of items affecting many economies, is likely to check business investment plans around the world.”

This sounds to us like a lose-lose scenario. It comes on top of data indicating that world GDP is already on a slowing trend as evidenced by new orders, industrial production, retail sales and trade. The World Bank recently joined the chorus by lowering its global growth forecast for 2019 to 2.6% - 0.3% lower than its estimate just six months ago. It has also reduced its forecast for global trade growth by a full percentage point in 2019 to the weakest rate of growth since the global financial crisis.

The US economy is now at the tail-end of the one-off Trump stimulus initiatives and is heading towards its potential trend growth rate of 2% or less. An IMF update report released in late June forecasts that US real GDP will average growth of around 1.7% between 2020 and 2024. We tend to be slightly more optimistic with a forecast of 2% trend growth but either way it is a long way short of general market expectations.

During June around 640 US companies and groups sent a letter to Mr Trump headed “Tariffs hurt the Heartland”. It said, amongst other things: “We remain concerned about the escalation of tit-for-tat tariffs ... we know first-hand that the additional tariffs will have a significant, negative and long-term impact on American businesses, farmers, families and the US economy.”

The US imports far more from China than it exports to China. Trade flows between the two will never be balanced no matter what Mr Trump may wish for. China simply makes a lot of “stuff” that the rest of the world demands – including products made by US companies with a manufacturing or outsourcing base in China. Global supply chains are now very complex. Disruption at one point of the chain can have a raft of unintended consequences.

The official newspaper of the Chinese communist party, the People’s Daily, included a rare warning in a recent editorial: “Don’t say we didn’t warn you” it said whilst hinting China may place an embargo on rare earth exports to the US. China dominates the global supply of rare earths and the US imports around 80% of its needs from China. This move would probably hurt China as much (or even more) than the US, but it demonstrates how foolish this spate of trade bullying has become.

History suggests that tariffs are easy to impose but never that easy to remove. We can only hope, therefore, that this “war” ends quickly before changes become entrenched. 

This wire is an extract from the 2019 Q2 edition of Pyrford's 'Pyrspectives' 

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Tony Cousins
Chief Investment Officer
BMO

Tony joined Pyrford in 1989 and headed its European and UK investment management activities before becoming Chief Executive and Chief Investment Officer in January 2011. Tony has a Masters of Arts degree and is a CFA.

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