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Do the Recent Trade Tensions Matter for the U.S. Economy?

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Do the Recent Trade Tensions Matter for the U.S. Economy?

Written by: Gabriela Santos

After being the hot topic of 2018, trade tensions had simmered down during the first few months of this year. This month, the heat has gotten turned up again, with the U.S. increasing tariffs to 25% on $200 billion of Chinese imports and with China retaliating with 25% tariffs on $60 billion of U.S. goods. In addition, preparations have begun to impose 25% tariffs on the remaining $300 billion of Chinese imports. Does this dynamic matter for the U.S. economy?

The negative effects of tariffs imposed since 2017 have been most evident for big export economies like those of Japan, Europe and China, with these countries’ manufacturing activity weakening significantly over the course of 2018. The U.S. economy has held up much better, thus investors in U.S. assets may be tempted to brush off recent headlines. However, these developments do matter for U.S. fundamentals for two reasons: 1) they increase the chances that the tariff fire may soon burn too hot, and 2) the smoke it generates is harmful itself.

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In terms of the fire’s strength, the average U.S. tariff rate has risen from a global low of 1.4% in 2017 to a developed market high of 4.5% today. At the moment, this year’s increase in tariffs is small and may lift U.S. consumer goods’ prices by only 0.2% this year, a manageable drag on consumer spending. However, the chances have now increased that a deal is not struck at all, resulting in the additional tariffs on Chinese imports. Should this occur, the heat on prices and consumers will be turned up significantly. The average U.S. tariff rate would increase to 7.7%, a feat only bested by Brazil. In this worst-case scenario, U.S. consumer goods’ prices could increase by an additional 0.6%, a significant boil for consumer spending.

In addition, irrespective of the strength of the fire itself, the smoke it generates can be quite harmful. With limited visibility on the future rules of the game, business confidence would fall, hitting investment spending. Lastly, the uncertainty it generates around future economic and earnings growth would depress investor confidence again, hitting risk asset prices and strengthening the U.S. dollar. This tightening in financial conditions would have its own harmful side-effects for U.S. consumers and businesses. Crucially, these negative effects would occur in the context of an economy less energized by fiscal stimulus than was the case last year.

Of course, a deal may still be struck between the U.S. and China towards the end of June. In this scenario, there is some volatility along the way, but consumers, businesses and investors are not burned too badly. However, the risk of an injury has now risen. This highlights the importance of having some safety guards in a portfolio, such as government bonds on the fixed income side and income and hedging strategies on the equity side.

 

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