Economic constraints likely to show Trump is all mouth and no muscle

Despite wielding the blunt weapon of tariff hikes, it is far from certain the president seeks a full-scale trade war

In his election campaign US President Donald Trump promised to put “America First”. After a slow start his administration has finally embarked on a number of measures designed to do this. Mixing national security and accusations of unfair trade practices, he has initiated three broad measures to protect US industry: tariffs on washing machines and solar panels, tariffs on steel and aluminium imports and targeted measures on $50bn worth of Chinese exports.

The irony of Trump’s trade war is that even if it is justified based on economics, which is highly questionable, it’s unlikely to benefit the US. The most likely effect of a trade war is higher inflation, which will push up interest rates and weigh on global and US consumers. Rather than a brave new world of US manufacturing, a trade war will tax US consumers and result in fewer, rather than more, jobs being created.

Which raises the question: is the threat of a global trade war as a direct result of Trump’s protectionist measures a moot point? The Trump administration’s drive to implement protectionist policies is not unique among recent US administrations. Ronald Reagan, for example, imposed trade restrictions on steel and textiles, among other industries, partly in response to the US’s deteriorating trade position with Japan, while George W Bush imposed tariffs on steel imports in 2002 (which were rolled back a year later).

However, trade definitely appears to be a higher priority for Trump than previous administrations. Being tougher on the US’s trading partners has been a longstanding concern of Trump’s. In his book The America We Deserve, Trump writes that “we’ve fallen into the habit of mistaking the easy availability of cheap, sweatshop-produced product for solid and sustainable economic stability…. What I would do if elected president would be to appoint myself US trade representative…. Our trading partners would have to sit across the table from Donald Trump and I guarantee you the rip-off of the US would end.”

Over the past few decades, the global economy has benefited from significantly lower barriers to global trade. In the US, the average tariff on imported goods has fallen from 20% in 1934 to just 1.5% prior to Trump’s recent announcements. Today, however, the world — and China in particular — sit across the negotiating table from Trump, and he is promising to stop the “rip-off’”. How far Trump is prepared to go is uncertain, but were he to deliver on his election campaign’s promise of increasing the effective tariff in the US to 10%, the US and the world economy would be in for a nasty shock.

Having downplayed the likelihood of any significant protectionism in 2017, markets have sold off in 2018 partly in response to Trump finally implementing some tariff increases. But it is still far from certain that he is pursuing a full-scale trade war. For a start, the initial measures he announced are relatively modest. Even if fully implemented, they affect less than 0.5% of the US economy. Furthermore, the probability seems high that the final outcome of Trump’s trade measures will fall far short of the opening salvo. For example, he initially threatened a 50% tariff on steel imports from China, Russia and other nonUS partners with quotas imposed on imports from US allies. However, this has been watered down to a 25% tariff on China and Russia, with exemptions on most other countries. Even this outcome could be further watered down in coming weeks.

Of course this may simply be a negotiating strategy. It is clear, however, that in a world of global supply chains, tariffs are a blunt instrument unlikely to achieve the desired effect. The aim of the steel tariffs is clearly to increase the cost of imported steel, to increase US steel production and reduce imports from the rest of the world. Since 2009, however, US steel prices went up by 50%, but production actually fell by 60%. Obviously something more than prices was at play, so it’s hard to see why this tariff is going to increase US production when the 50% price increase since 2009 did not.

More broadly, in Unbalanced: The Codependency of America and China, Stephen Roach argues that Chinese labour input in the manufacturing sector was $2.30 an hour, while the average for the foreign suppliers ranked two to 10 was $26 per hour. Raising tariffs on Chinese manufacturers would simply shift the US towards higher-cost producers, with negative consequences for the US consumer.

The US may well end up with lower output and a bigger trade deficit.

Just how much of an impact will Trump’s taxes have on the world economy?

In the current form, not much. Based on a study by Goldman Sachs, the measures affect less than 0.5% of the country’s GDP. Assuming no retaliation by trading partners, the measures should marginally increase US output but they will also marginally increase US inflation. Nonetheless, the results will be hard to notice.

Should the US increase tariffs to 5% and their partners retaliate, this scenario would result in a larger, albeit still modest, negative effect on the US and the global economy.

Of course, as is evident from the initial market response, any assessment of the effect of protectionism must take into account the effect on financial markets. Another scenario modelled by Goldman Sachs accounts for a fall in risk assets resulting from a five percentage point increase in global tariffs. This scenario would cause a hit to global GDP of about 0.3%.

This in itself suggests that there are market constraints to the ability of the US to implement a significant protectionist trade agenda.

It is very questionable whether a protectionist trade policy will achieve the targeted result and it is unlikely that it will come without a negative effect on the overall US and global economy. For a president fond of pointing out the positive effect he has had on the equity market, this might prove too bitter a pill to swallow.

That said, it is clear that Trump is willing to take some risks to recalibrate global trade and security relations. Coming after decades of increased globalisation, this is likely to inject greater uncertainty into the global economy. This coincides with a point in time in which global monetary policy, like an ocean liner, is gradually changing direction. The likely outcome for financial markets, as has already been the case in 2018, is higher volatility.

The trade tariff measures announced by the Trump administration affect only a small share of global GDP and are likely to be watered down in their final implementation. Furthermore, for now there do not appear to be any significant further measures being considered by the US. The bearing of the existing trade measures announced by both the US and China on global markets is therefore likely to be small.

Given that global and local equity markets have pulled back since January, the effect of the tariffs appears to already be priced in and global equities should deliver reasonable returns for the balance of the year, in the absence of any unexpected shocks to the global economy. Of course, should the Trump administration pursue ever more aggressive trade measures, global growth is likely to slow and global inflation to accelerate. This is likely to lead to further contagion to risk assets, with global equities likely to fall. In our view, however, this is a risk rather than a key theme for financial markets.

We may not have a crystal ball that can tell us what the politicians will do, but electorally and economically it doesn’t make rational sense for Trump to trigger a trade war.