Trade War I: Rising Recession Odds
The saber-rattling turned into a trade war between the U.S. and China on Friday. That’s when the Trump administration slapped a 25 percent tariff on $34 billion of goods imported from China. It was imposed on Chinese machinery, medical instruments, aircraft parts, and other goods—to punish China for years of intellectual property theft.
Beijing immediately retaliated by targeting mostly US farm products, seafood, and autos—also valued at $34 billion—to be taxed at the same rate or higher. Indeed, China raised its tariffs on the US automotive sector, and they are now 40 percent on vehicles that are mostly built by BMW, Daimler, and Ford.
Trump is considering targeting another $16 billion of Chinese imports for the levy. Last Thursday on Air Force One, Trump suggested that the final tariff total could exceed $500 billion, almost the same amount that the US imported in total last year. China’s Commerce Ministry accused the US of “bullying” and igniting “the largest trade war in economic history.”
Somebody had better blink soon because the risk of a recession caused by a widening trade war just increased significantly. Until Friday, our house view at Yardeni Research has been that the prospects for the US economy and the outlook for the US stock market remain upbeat. That assessment came with a hedge clause: “barring a trade war.” That clause is no longer a hypothetical risk.
China may be more at risk of falling into a recession than the US. If so, then the Chinese government may blink and make concessions to get Trump’s dogs of war to back off and stop their barking and biting. That would trigger a huge relief rally in global stock markets. But that’s not a sure bet. Instead, the war could escalate. Consider the following recent and relevant developments:
(1) Copper flashing Code Red for Red China. Dr. Copper raised the odds of a recession in recent days. The metal with a PhD in economics dropped 14.6 percent to 281.3 cents per pound from its June 8 peak through Friday, to the lowest level in a year (Fig. 1). China alone accounts for around 40 percent of global copper demand, closely tying copper’s price to the health of the world’s second-largest economy.
Copper is one of the 13 components of the CRB raw industrials spot price index, which is our favorite indicator for tracking global economic activity (Fig. 2). So far, the index is holding up reasonably well under the circumstances.
The price of copper is also highly correlated with the price of a barrel of Brent crude oil (Fig. 3). The price of oil remains strong, reflecting the resilience of the global economy (so far). Of course, Venezuela is exporting much less oil, and Iran’s oil exports soon will be depressed as a result of Trump’s sanctions imposed on the country. On the other hand, US crude oil production soared to a record 11.0 mbd at the end of June, up 1.6 mbd from a year ago and 2.5 mbd from two years ago (Fig. 4).
(2) China addicted to exporting to US and stealing US technology. Over the past 12 months through May, US merchandise trade data show that the US imported $523.0 billion from China (21.5 percent of total US imports) and exported only $133.7 billion to China (8.3 percent of total US exports) (Fig. 5). The resulting deficit of $389.3 billion accounted for 47.5 percent of the U.S. trade deficit over the past 12 months (Fig. 6).
Chinese data show that exports to the US totaled $473.3 billion over the past 12 months through May, accounting for 18.7 percent of Chinese exports over that same period (Fig. 7).
It may be that the biggest downside for China in Trump’s new world order is losing ready access to US technological innovations. Trump’s biggest beef with China is unfair trade practices that have allowed the Chinese essentially to steal US technology by requiring US companies seeking to produce in China to form joint ventures with local companies. This issue may take a long while to resolve to the satisfaction of the Trump administration.
(3) Financial markets starting to reflect relative pain. In addition to the recent swoon in the price of copper, China’s Shanghai-Shenzhen 300 (in yuan) dropped 4.2 percent last week and is down 16.5 percent ytd (Fig. 8). There’s a reasonably good (though not great) correlation between the China MSCI stock price index (in yuan) and the price of copper (Fig. 9). The former is down 4.4 percent ytd, while the latter is down 14.2 percent ytd. Both dropped sharply last week.
Meanwhile, the S&P 500/400/600 stock price indexes are up 3.2 percent, 4.7 percent, and 12.1 percent ytd. The significant outperformance of US stock market indexes relative to the Chinese stock price indexes suggests that investors believe that China has more to lose in a trade war than does the U.S.
(4) Collateral damage in emerging economies. The price of copper is also highly correlated with the Emerging Markets MSCI stock price index (in local currency) (Fig. 10). The latter is down 4.7 percent ytd. That’s not surprising since China is included in the former. So far, China’s M-PMIs and NM-PMIs show no evidence of an economic slowdown through June. More broadly, these indexes for emerging market economies edged up in June, but are down from recent highs at the beginning of this year (Fig. 11 and Fig. 12).
(5) Flat yield curve in US reflecting more alarm abroad than at home. Proliferating protectionism certainly helps to explain why the 10-year US Treasury bond yield remains around 3.00 percent since the start of this year despite two hikes in the federal funds rate. As a result, the yield spread between the 10-year and 2-year Treasuries fell to 29 bps on Friday, the lowest since August 8, 2007 (Fig. 13). Coinciding with the relative calm in the US bond market has been the strength of the dollar (Fig. 14). This suggests that there has been a flight to quality by global investors to the benefit of US Treasuries and blue-chip US stocks.
Trade War II: Blinking Europeans?
Earlier this year, on March 1, Trump said he would impose duties on foreign steel and aluminum imports (which were implemented on May 31), drawing the ire of the European Union and Canada, which fret that he may go after automakers next. Last week came signs that European leaders may be willing to negotiate a deal that would cut existing European tariffs on American cars in an effort to head off a widening of the trade war.
Trump has threatened to impose tariffs of 20 - 25 percent on auto imports. He has asked the Commerce Department to study whether vehicle imports threaten national security, the same argument that the US used to impose steel and aluminum tariffs. US cars are subject to a 10.0 percent tariff when they are exported to Europe, compared with a US tariff of 2.5 percent. The US, however, also has a special tariff on pickup trucks of 25 percent.
According to CNBC, the US exported 267,000 autos to China last year and has a trade surplus of $6.4 billion in the auto sector with China, but it has a deficit of about $32 billion in the automotive sector with Europe. Furthermore: “Analysts note that the irony is that Daimler and BMW manufacture vehicles in the U.S., as do Japanese manufacturers Honda, Toyota and Subaru. Mercedes-Benz U.S. International says on its website that it manufactures 286,000 vehicles at its Tuscaloosa, Alabama, plant, exporting them to 135 countries last year. It says it exported 70 percent of the SUVs it produces, making it the second largest exporter in the U.S.”
Trade War III: Method to Trump’s Madness?
In a 3/2 tweet, Trump declared: “When a country (USA) is losing many billions of dollars on trade with virtually every country it does business with, trade wars are good, and easy to win. Example, when we are down $100 billion with a certain country and they get cute, don’t trade anymore—we win big. It’s easy!”
Trump is betting that the trade skirmish will prompt American companies to return operations to the US. He must also believe that the US economy can absorb protectionist shocks better than the economies of our major trading partners. If so, then according to his script, they should fold ’em, while he holds ’em.
There may be method to what is widely believed to be Trump’s madness about protectionism. Trump’s protectionist campaign started on January 22, when tariffs were slapped on solar panels and washing machines. A month earlier, he signed the Tax Cuts and Jobs Act on December 22 of last year. That legislation certainly provided a fiscal boost to the economy, which may very well absorb the shock of Trump’s “art of the deal” applied to trade negotiations.
Previously, I’ve observed that no other President in the past has been simultaneously more bullish (tax cuts) and bearish (tariffs) than President Trump. That’s why the S&P 500 has been zigzagging all year. At the same time, the US economy has been strengthening. Consider the following recent developments:
(1) Pedal to the metal. The American Trucking Association reported that the ATA truck tonnage index rose 7.8 percent y/y to yet another new record high during May (Fig. 15). That’s remarkable given all the chatter about a shortage of truckers. Over the past 12 months through June, payroll employment in the truck transportation industry rose 25,000 to 1.48 million, matching March’s record high. Yet average hourly earnings for truck drivers remains relatively subdued at 2.3 percent y/y (Fig. 16).
(2) Lots of jobs. As Debbie discusses below, private payroll employment is up 2.36 million over the past year through June. Our Earned Income Proxy for private-sector wages and salaries is up solidly, by 4.9 percent y/y through June.
Trade War IV: The Fog of War
The risk is that the first round of trade skirmishes escalates into a widespread trade war. The Chinese might not blink. As the 7/5 Bloomberg observed:
“China also has other ways to retaliate by going after U.S. companies such as Apple Inc. and Walmart Inc., which operate in its market and are keen to expand. It could introduce penalties such as customs delays, tax audits and increased regulatory scrutiny, while more drastic steps include devaluing the yuan or paring $1.2 trillion holdings of U.S. Treasuries.
“Beijing has shown little interest in making fundamental changes to its economic model. President Xi Jinping has balked at U.S. demands to stop subsidizing Chinese firms under his plan to make the nation a leader in key technologies by 2025.
“The strength and size of both economies means the fight could rage on for years.”
Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.
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