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March 2018 | Paul Cavey, Global Bond Strategist; Michael Medeiros, CFA, Global Bond Strategist

Trade war, détente, or other? Gauging options and outcomes for proposed US tariffs

Negotiators have three months to work out a deal with Beijing. While media headlines may scream “trade war,” we see paths to a more constructive outcome if certain conditions are met.

We believe that the Trump administration’s newly announced tariffs on US$60 billion worth of goods imported from China are the starting point of several MONTHS of negotiations. While media headlines may scream “trade war,” what happens over the next three months could lead to a much different outcome. In our view, escalation into a trade war remains a significant risk that we continue to focus on, but we do see paths to a more constructive conclusion if certain conditions are met in the near term.

The planned tariffs were prompted by the US government’s investigation into Chinese intellectual property (IP) practices per section 301 of the Trade Act of 1974. Section 301 authorizes the President to take action or retaliate against a foreign government’s policies that either violate a trade agreement or unfairly restrict US commerce.

The Trump administration has set upon a course of action that will take three months to complete. First, the US Trade Representative Robert Lighthizer will publish over the next 15 days a list of goods to be taxed. This will be followed by a 30-day comment period and an additional window for rounds of negotiations and guideline-setting for any restrictions. Deadlines for this process are in June.

By creating a lag before any policy goes into effect, the US is signaling its willingness to negotiate with China. This is certainly constructive in our view, although the administration has suggested it would enforce the tariffs bluntly if negotiations do not go well. If China is willing to discuss some of the US’s chief concerns and conditions, such as IP practices, auto tariffs, and access to China’s financial sector, the US will likely seek a pragmatic near-term solution.

US concerns and desired outcome

In our view, it seems reasonable that a positive outcome from a US perspective would include progress on a few key areas:

  • Evidence of greater transparency, specificity, and an easing of technology and IP transfer practices for US firms
  • Recourse for US companies to set market-based terms in licensing and technology-related deals
  • Enhanced cybersecurity for the protection of IP, trade secrets, or confidential business information
  • Further opening of China’s economy and a reduction in tariff and nontariff trade barriers

China’s options

Any progress likely depends on China’s perceptions of President Trump’s objectives. If Beijing thinks he is merely seeking a short-term, headline-grabbing political win, then we believe it will probably play along and buy more US goods. If, however, China thinks that Trump is aiming to upend China’s development model (something that Peter Navarro, Trump’s director of Trade and Industrial Policy, has implied), then it will likely respond more negatively.

We believe there is a third option as well, in which China opens up its economy in more fundamental ways. China could cut auto tariffs, for example, or move toward strengthening trading links with Europe. Several of China’s top political leaders, including Li Keqiang, premier of the State Council; Liu He, the main economic adviser to Chinese President Xi Jinping and a newly promoted vice premier; and Yi Gang, the new governor of the People’s Bank of China, have recently spoken in these terms.

In brief, we see three options for China:

Cut US imports

If China thinks the move is ideological and nothing can be done to dissuade the US from deepening protectionism, it may cut US imports and penalize US firms operating in China. This would demonstrate displeasure with US tariffs and could result in a US-China (and possibly global) trade war.

Increase US imports

If China thinks President Trump wants a quick political win, it may decide to increase imports from the US, particularly on big-ticket or high-volume items such as aircraft or soybeans. China might be fine with Trump claiming “victory” with such an outcome, as nothing fundamental in the trade relationship would change, yet it would likely avert or de-escalate the risk of a trade war.

Open up China’s economy

If China thinks the US can be persuaded to take a pragmatic approach, in part by dismantling the unusual coalition of US businesses and geostrategic hawks holding sway in Washington today, then Beijing may decide to open up China’s economy further, allowing foreign firms to buy Chinese competitors, for example. We believe this choice would be generally positive for global trade.

The Europe question

There is one more angle to consider: China might open up its economy to Europe specifically, by pushing through the EU-China Comprehensive Agreement on Investment (CAI). Negotiations on the CAI started in 2012, but progress has been slow. We see some obvious reasons why China would have a more acute interest in pushing that through now:

  • To show the US what it loses out on via protectionism
  • To try to shift the axis of world trade and economic activity away from the Pacific Rim-US and toward Eurasia-China. This would be consistent with China’s ambitious, multidecade Belt and Road Initiative.
  • To push through structural domestic economic reforms. In the last 30 years, the dual themes of “reform” and “opening” in China have gone hand in hand. Chinese premier Zhu Rongji complied with certain requirements to enable China to join the World Trade Organization in 2001, for example.

What happens next?

Ultimately, the size of the problem may depend on whether and to what extent the US or China broadens the scope of protectionism. For now, some of the recent market concerns may stem less from the actual policy proposals and more from the timing of recent announcements, which have coincided with tightening by the US Federal Open Market Committee (FOMC) amid full-employment fiscal stimulus.

Structurally, the average global tariff rate has fallen significantly since the late 1980s, creating an important support for productivity growth in the US through comparative advantage. Trade protectionism represents a negative supply shock and a tax on the users of any protected commodity. Protected industries tend to be less productive, elevating the probability of cost-push inflation (especially when implemented at full employment). In the medium term, these measures can be deflationary if private-sector saving rates rise and dampen animal spirits, particularly capital spending.

In the current environment, a substantial increase in tariffs could dent fiscal multipliers and tighten financial conditions. The FOMC would be in a difficult spot, facing a deteriorating growth/inflation trade-off that could lead to a regime in which both stocks and bonds suffer from rising inflation volatility.

For China’s part, we should note that notwithstanding trade dynamics, the decision to open up China’s economy may well depend on President Xi’s worldview. For the last five years, economic opening has stalled in China. Whether Xi has not had time to pursue this because he has been focused on consolidating power, or whether he simply doesn’t believe in further opening, matters a great deal in our opinion. For now, we lack enough information to conclude which is the case. It is encouraging that the economic reformer Liu He has just been promoted, and we feel that any signals of China’s willingness to make the concessions needed to push CAI though would also be positive.

Views expressed have a 6 – 12 month horizon and are those of the authors. Views are as of March, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. This material is not intended to constitute investment advice or an offer to sell, or the solicitation of an offer to purchase shares or other securities.


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