The Trade War was the undisputed theme on Wall Street and five days after the Sunday morning tweet, the threatened tariff hikes came to be. Despite being caught completely off-guard last weekend, China sent their trade team to Washington as planned. The Chinese delegation met with President Trump’s trade team Thursday evening with nothing really to report. Discussions continued Friday, but the consequences of no deal have already been activated. The game of chicken is on, and the American President did not back down. Seemingly feeling confident with a Stock Market still near all-time highs and a US economy that grew over 3% last quarter, Trump was clearly willing to play hardball against China trying to take advantage of free and fair global trade. In a series of tweets Friday morning, President Trump said trade talks with China are proceeding “in a very congenial manner” and that there is “absolutely no need to rush.” As the President always says, I guess we’ll see.
US Customs and Border Protection imposed a 25% duty on nearly 6,000 categories of products leaving China after 12:01 am eastern standard time Friday. Airfreight shipments will be impacted right away, but seaborne purchases from China before midnight were reportedly not subject to the new tax as long as they arrived in the US before June 1st. They will be charged the original 10% rate. Perhaps the next three weeks offers time and some hope that the two sides will want to continue to negotiate terms. There is an important event in June. It will be held in Japan. It’s the annual summit for the Group of Twenty nations, otherwise known as the G20. This could mark an important milestone to reach an agreement since it is when the Chinese and American Presidents are next scheduled to meet.
Initial estimates suggest the higher tariffs would reduce US gross domestic product by 0.3% in 2020. They are expected to hurt China more, cutting output by 0.8%. That translates to a cost to the US economy of around $29 Billion by 2020, and a hit to the global economy of 0.3% or more than $105 Billion. So it’s not huge, but it is clearly not insignificant either. The numbers I’ve seen batted around, account to an increased cost of roughly $800 per year for a family of four. The American Consumer will be on the hook for some of the increase in costs. There’s no getting around that. Plus, American companies will experience higher costs, which will force management teams to either lower capital investment for the rest of the year and/or reduce profit outlooks. In addition, China could look to other foreign sources to replace the American goods it purchases. Germany represents an obvious alternative. The Market is hyper-focused on this.
There isn’t a lot that China can do to retaliate since it has such a trade surplus with the United States. But one area of leverage that China does have is US debt. China owns over $1 Trillion in US Treasuries. They are the largest foreign owner, just ahead of Japan. Though a really high number, China’s Treasury holdings represent just 5% of total US debt. Regardless, if China were to sell Treasuries in the open market, it would likely send interest rates spiking which would increase American borrowing costs. But realistically, that would hurt China as well because it already has a debt problem and US Treasuries are its most desirable form of liquidity. It would also set off a global financial crisis, which China does not want. China will likely have to impose non-tariff measures on US companies such as delaying regulatory approvals, encouraging national boycotts of American products, increasing customs scrutiny which can cause agriculture goods to rot and redirecting government purchases of US goods to goods from other countries.
For the time being, according to our Washington sources, the most significant indicator will be how much China is willing to revert to the original text of the agreement after reportedly reneging on critical aspects of the mutually agreed upon deal in recent weeks. The optimistic scenario is that talks continue and the two sides announce a future date for Trump and Xi to meet, with that most likely being the G20 summit. A commitment to further discussions is better than a deal collapsing. But it’s important to understand that there are two issues still at play. One is on trade, and the other is spying and theft. A deal on trade is the easier issue and one that has the highest probability of being tackled. The issue of intellectual property theft and spying is so complex with grave implications for decades to come. It has a Cold War feel to it and that is not something that will be easily overcome. Both leaders are looking for a win. But of great significance, President Trump has an election next year. President Xi is in office for the rest of his life. China is really good at stalling. That’s a big risk right now, but the increased tariffs put a price on any delay.
So for now, we investors are forced to have to deal with this near-term whipsaw price action driven by headlines, tweets and speculation. We are long-term investors who are used to dealing with short-term issues. After a bruising week, the DOW and S&P closed Friday in the green. But it’s a long game with so many moving parts. We remain defensively positioned and outlined our thesis last week. For reference, you can re-read last week’s piece here.
We will be following developments over the weekend very closely. You can count on that. It’s sure to be covered on Twitter. As always, we’ll be back, dark and early on Monday.
Happy Mother’s Day!
This weekend we celebrate Mother’s Day and want to recognize our office moms: Meredith, Debbie, Nancy, Maria, Ayse, Leah and mom-to-be Kim. From our Bedell Frazier family to yours, Happy Mother’s Day!