There is plenty of media coverage focused on the continuing trade negotiations between the USA and PRC (Peoples Republic of China). The markets got all flustered the last few days (and likely today) as no trade agreement was reached and President Trump set forth addition tariffs on $200 million of goods across several thousand products coming into the USA. He furthermore threatened to raise tariffs on an additional $300 billion more goods coming in from the PRC.
A few questions one must ask oneself:
- Why are the tariffs being implemented?
- Are these tariffs material to the US economy?
- Can the tariffs be avoided?
- Can the tariffs be reversed and if so, when?
- Are the markets overreacting to the tariffs?
Why Are Tariffs Being Implemented
We must begin by understanding the history behind the World Trade Organization (WTO). The WTO was founded in 1995 after what is referred to as the Uruguay Round of negotiations, replacing the existing GATT (General Agreement on Tariffs and Trade). The WTO was organized to deal with the rules of trade between nations. At it’s founding, the PRC was not a member of the WTO.
The PRC entered the WTO in 2001. A deal was struck such that China, in return for opening and liberalizing its markets could join the WTO. However, at the time, the PRC was considered an emerging economy. As such, the WTO permitted China to exact large tariffs on the import of goods, especially from the United States.
When the PRC entered the WTO, its trade imbalance with the US was significantly smaller on an annual basis than it is today – see the US Census Bureau data on trade with the PRC.
Fast forward to 2016 when President Trump was elected. The PRC was by then the world’s second largest economy. Yet, it still was given favorable tariff provisions by the WTO. The greater the trade imbalance with the PRC, the more US Dollars the PRC held. Those trade proceeds were in turn being reinvested in US Treasury Securities. Essentially, the PRC was lending the USA money for our citizens to buy their goods on unfavorable trading terms. The need for the PRC to still impose large tariffs on imports from the US was no longer necessary. Furthermore, the PRC is notorious for stealing intellectual property and technology from US firms. This is called piracy in trade terms.
Presidents Clinton, Bush (43) and Obama allowed the PRC to flourish in trade versus the USA without considering the one-sided nature of such trade. It was not a Democratic or Republican issue. These Presidents simply did not recognize or conceptualize the burgeoning trade problem. They were after all politicians not business people.
President Trump has said that enough is enough. Hence, he began a bilateral negotiation for a new Sino-US trade agreement which would free up trade on a more even playing field and eliminate piracy. All seemed to be moving along (please note that such negotiations are tedious and complex) until the last month when the PRC seemed to balk on several already agreed upon points. It is hard to say what, but I am hearing that the PRC was unwilling to change its own laws to satisfy the terms of the new trade agreement.
So, trade talks broke down and President Trump decided to level the playing field on his own by enacting new tariffs on China. Interestingly enough, the US Constitution states that, “The Congress shall have the Power to lay and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defence and general Welfare of the United States; but all Duties, Imposts and Excises shall be uniform throughout the United States.” However, FDR convinced Congress to transfer such powers over tariffs to the President and since then the office of the President could exercise such powers.
Lastly, let’s not forget that the PRC is still a centrally managed Communist government and operates in a different way than the US.
Are These Tariffs Material to the US Economy
The answer is that the tariffs could have some impact to the economy, but the magnitude will not be large. I thought that White House Economic Advisor, Larry Kudlow; gave a well thought out and balanced explanation of what impact the new tariffs would have on the economy; with Chris Wallace yesterday morning.
Please be aware that I hold Larry in high regard and the two of us know each other “behind the scenes.”
The US economy is approximately $21 trillion. US imports from the PRC represent approximately 2.5% of the size of the US economy. At most, the US economy would, in my opinion, in GDP terms take a 0.5% hit to its economy, but more likely, 0.2% or less. Larry Kudlow quoted a 0.2% impact to the economy.
Can the Tariffs Be Avoided?
Yes, they can. However, there is, in economists’ terms the short-term and the long-term way of looking at things. In the short term, producers and consumers will look for domestically produced substitutes. That might not be a perfect fit, hence we will be forced to buy some higher priced goods in the short-term. In the long-term, American producers are already domesticating their supply chain. In part, we can thank the Tax Cuts and Jobs Act of 2017 for that shift in the supply chain, as massive amounts of capital were repatriated to the USA and keeping capital in the USA was given tax advantages in the future.
Can the Tariffs Be Reversed and If so, When?
With the Presidential powers to control tariffs, President Trump can and will reverse any newly enacted tariffs when a new trade deal is struck, or should he believe that the PRC has learned its lesson, so to speak. I continue to believe that a deal will be agreed upon by the end of the second quarter, but I am not racing out to place any bets.
Are the Markets Overreacting to the Tariffs?
They sure are. What I can say is that the stock market traders and pundits will convince you that the next correction or bear market is just around the corner. It is not. After reaching new all-time highs last month, the market needed a breather. Sometimes a pullback happens in need of a reason. So, we have that reason. With earnings for the first quarter now mostly all reported, and no significant economic data out till June, the market was ripe for some backing and filling.
I would note that in the last several sessions, early selloffs have been bought. That tends to be an indicator of general market strength. Mondays are always the worst trading day of the week. So, expect an early slide today. Then I would deploy new capital around 10:30 AM when I expect the markets to trough for the session.
Disclosure: At the time of this commentary Scott Rothbort, his family and/or clients of LakeView AssetManagement, LLC was not long any positions mentioned – although positions can change at any time.
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