Who will win the trade war?

As we finished off our eggs last Easter weekend, protectionism entered a new dimension.. increasing escalation into a trade war.  Is this the issue that will cause the Crash of 2018?

With the global economy ticking along nicely alongside benign inflation and stock markets reflecting that happy state, why put it all at risk? Why turn what was a sweet egg into a Humpty Dumpty that risks a very big fall? The answer is simple: Hegemony. Hegemony is the political, economic, or military leadership, predominance or control of one state over others. And therefore the avoidance of hegemony or being dominated is equally important. No one would fault Donald Trump’s bid to make America Great again if everyone benefits through an increasingly booming world economy and it is not at any other nation’s expense. But the mantra and the Trump administration’s policies imply greatness in both time and relative position, ie hegemony Even if the policy of protectionism is inspired by a need to redress a perceived imbalance that has grown over time, someone else (if not all of us) will suffer: a curate’s egg.

“We are not in a trade war with China, that war was lost many years ago by the foolish, or incompetent, people who represented the U.S.,” Trump tweeted“Now we have a Trade Deficit of $500 Billion a year, with Intellectual Property Theft of another $300 Billion. We cannot let this continue!”

This week’s newsletter uses HEGEMONY to explain the likely outcome.

History shows that no one wins an actual trade war. The depth of the adverse Economic impact relies largely on the scale and duration. And that itself is influenced heavily by the Geopolitical situation at the time and to what extent the threat or actuality of a trade war Escalates. The Market’s reaction throughout largely depends on the extent to which investors and traders believe the trade war and impact will continue until a resolution either way. Opportunities therefore present themselves when that perception changes or fluctuates. But until such time that Negotiation can secure a resolution one way or the other, it begs the question  whY:

HISTORY shows that nations cannot win a trade war.

Donald Trump said “Trade wars are good, and easy to win.” 

The evidence doesn’t support this.  It is no coincidence that the two most prominent trade wars of the twentieth century helped precipitate the two largest percentage stock market falls of the century.

The Smoot-Hawley Tariff Act of 1930 is attributed as one of the largest causes of the 1930s Great Depression. By imposing steep tariffs on roughly 20,000 imported goods America’s trading partners, led by Canada, retaliated with tariffs on United States exports, which plunged 61 percent from 1929 to 1933. The tariffs were repealed in 1934. But its enactment in 1930 understates its role in the 1929 crash. It was born actually as an agricultural tariff during the election of 1928 helping to scupper the League of Nations idea of a ‘tariff truce’. Drafted in January 1929 the Bill was passed by House of Representatives in June 1928 and passed onto the Senate which only passed it 8 months after the Crash. By September 1929, the month before the Crash, the Hoover administration had already noted protests from 23 trading partners at the prospect of higher tariffs.

The PERSISTENT threat of protectionism and retaliation underpinned the Stock Market crash of 1929.

Similarly, Reagan’s semi-conductor tariffs against Japan announced on April 17th1987 marked an important step in deteriorating international relations. This account of 1987 neatly highlights the similarity to 2018 and how a trade war was the arguable trigger for the Black Monday crash.

The persistent deterioration in international relations underpinned the 1987 crash.

The economic impact of a trade war depends largely on the scale and duration.

History shows that no one wins in a full-scale trade war. Its creates inflationary pressures, distorts production away from the most efficient producers, hurts consumers and instils a level of uncertainty that deters investors and potentially creates an investment gap that has a later detrimental impact on both employment and growth.

The American consumer would arguably be the most affected by a trade war as tariffs force up rices,  create general inflationary pressure and particularly squeeze the margins of manufacturers that use the higher priced steel and aluminium such as aircraft and auto manufacturers.   As Powell said on Friday “Tariffs can push up prices, but again it’s too early to say whether that’s going to be something that happens or not.” But the implication for interest rates and therefore economic growth would be clear.

The scale of the future impact of a trade war on the global economy and stocks is currently difficult to assess at the current level of escalation.  They remain proposals (for 60 days) and limited if not restricted. Adam Slater, Oxford Economics sees “the scope of the moves to date as relatively limited” and having only “a marginal impact on the US economy”.   As they stand now they are unlikely to make a dent in either the federal government deficit or the US goods trade deficit – possibly a false justification for further escalation.

None of the top five US import goods from China are affected. The tariffs are targeting high-tech and industrial sectors where China seeks to be a world leader by 2025. One third of American TVs and 40% of aluminium products come from China. The US has also excluded products where penalties might disrupt the US economy or those that would hit consumers hard. In total, these amount to annual imports worth about $50bn, not huge when compared with the $2.4tn of US total goods imports in 2017 or the $506bn of US imports from China.

It is interesting to note that  the 25% tariffs China is imposing on 106 American products in response also amounts to $50bn. Soyabeans are by the biggest current concern for US producers. Of $22bn of US soyabean exports, 56% goes to China showing both the selectivity and  tit-for-tat nature of retaliation that is likely to serve as a precedent for future escalation.

The Geopolitical situation at the time holds the key to how far this escalates. The current conditions are not yet conducive to a full-out trade war. Clearly Donald Trump’s agenda has ruffled international feathers. But the agenda is so forthright that it has left many leaders in a position where they do no want to alienate one of the world’s most powerful leaders, economy and market for fear of reprisals and being excluded. Whereas in the 1920s-30s America’s isolationist approach and the somewhat disjointed late 1980s approach of G7 (after G5 Plaza in 1995) facilitated widespread retaliation in one form or another, global unease with the Trump agenda is probably still too young to encourage the creation of camps. And even then it is doubtful the camps would be so one-sided as the 1920s or 1980s.

The speed of the escalation is the most worrying aspect of the phoney war so far as historically it is unprecedented.

But this speed is as much a function of a modern world where both these two leaders are able to make decisions and act swiftly.  So when Xi calls swiftly for Europe to join in retaliation it is not just likely to fall on deaf ears (until such time as Trump turns on Europe) but the speed of the European response is also likely to be slower. This is actually helpful as when leaders respond so swiftly there is a risk of over-reaction and further escalation. This leaves the phoney war an uneasy bilateral affair. It also maintains  a latent threat to the stock market and Dollar until it escalates not just in the number of tariffs but also the scale and spread of tariffs to other countries. This will also likely fashion the market’s reaction.

Market reaction throughout largely depends on the extent to which investors and traders believe the trade war and impact will grow until it is resolved either in peaceful resolution, stalemate,or a crash. We have noted previously the typical reaction to US-led international tension.

(Also see Protectionist Fractals in ‘Making Sense’, our newsletter of Mar 18th)
Markets hate uncertainty in two ways. Firstly and obviously stocks and USD sell off on any tariffs. But, secondly, unless it is clear that this will lead to either further escalation or resolution, that very uncertainty also limits and quite often unwinds the move – what we have previously described as a ‘stasis’. This is evidenced by SPX’s reaction to every Tariff news:
Trading opportunities therefore present themselves in two forms and two time frames. The first is short term fading quite aggressive two way volatility as reflected by the Tariff Event fractal (a comparison to the current price action is available in the Evidence section of our SPX analysis page).

The second is the medium term resolution of the trade war either peacefully, a stalemate,or a crash. This perfectly reflects the 1987 Major Stock Inflection and therefore, given the price action of the last week, a clear prognosis for both the stock market and trade war.

This could be the beginning of an aggressive bilateral trade war that could conceivably lead to a full scale trade war. But at the moment that is not clear. It has all the hallmarks of a classic Trump negotiation where he starts with an aggressive posture only to back down in return for some major concessions. Similarly China’s response has the ring of a threat not affirmative action. White House economic adviser Larry Kudlow has made it clear US tariffs are only proposals, and Beijing has responded with only a tentative menu of prospective tariffs. True there has been aggressive rhetoric with Trump remaining defiant and arguing the pain (and market fluctuations) will pay off in the end and China accusing him of shooting himself in the foot if he didn’t back down from such “extremely wrong” threats. But despite this, both nations have said they would prefer to negotiate. A trade war is a tail risk until such time both parties can find a way of walking away from the negotiating table with their honor intact. As both George Bush and Clinton did previously.

Notwithstanding any further tariff proposals, negotiation is the next logical step. Further retaliatory actions with time lags and exemptions are ironically a further indication they will sit down and negotiate. The tariff proposals are a tactic then but one that could backfire. It is doubtful the US administration has a strategy, a proper risk assessment, or an idea how this will end.

It therefore begs the question:

Why take the risk of a stock market crash and a possible recession. If its not broke don’t fix it. We firmly believe history has two answers. Firstly, that the same underlying conditions of the 1920s and 1980s have led to a similar trade dispute should be no surprise.  Secondly and finally, If and when international relations deteriorate to a point where other nations become fully involved then we can be more confident the’game is afoot’.

In the words of Henry Kissinger

.. or after a very big fall.

Here’s to the very best

Ed Matts

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