There will be no win­ners in this trade war

Yorkshire Post - Business - - BUSINESS / VOICES - Guy Stephens Tech­ni­cal In­vest­ment Di­rec­tor, Rowan Dart­ing­ton

The last few weeks, since early Fe­bru­ary, have been dom­i­nated by talk about resur­gent in­fla­tion and lat­terly a US trade war with China. This was sparked by a monthly jobs re­port in the US which mea­sures em­ploy­ment growth and in par­tic­u­lar, wage growth. This caused US eq­uity mar­kets to fall by 10 per cent at one point and im­me­di­ately burst the com­pla­cent, low volatil­ity, record break­ing, bull mar­ket bub­ble that had been in­flat­ing through­out 2017.

These are slightly bizarre de­vel­op­ments. Firstly, we were under the im­pres­sion that wage growth, or the lack of it, was the one fac­tor from the QE in­spired re­cov­ery that has not oc­curred since the credit cri­sis. Just as we fi­nally get some ev­i­dence that the ben­e­fits of all that stim­u­la­tion is end­ing up in the wal­let of Joe Six­pack, in­vestors run for cover.

Se­condly, I am not sure what China is sup­posed to do about its trade deficit with the US. If the US was able to com­pete by man­u­fac­tur­ing more cheaply then im­ports from China would fall but this will be dif­fi­cult when wage costs are go­ing up in the US.

The logic on wage growth caus­ing in­fla­tion goes some­thing like this. In a tight labour mar­ket, busi­nesses strug­gle to re­cruit skilled staff and con­se­quently have to of­fer higher salaries to at­tract them away from com­peti­tors. Those same com­peti­tors then have to do the same to re­tain their staff and also to at­tract new mem­bers and so on. That’s great news for the staff but then the com­pany has two choices.

Ei­ther ab­sorb the ex­tra cost which hits profit mar­gins and earn­ings or pass the cost on and raise prices. If ev­ery­one is do­ing it, then there is no com­pet­i­tive dis­ad­van­tage and then you have a spi­ral which gets out of con­trol un­til in­ter­est rates go up caus­ing a re­ces­sion and then a lot of those orig­i­nal jobs go.

The logic on trade tar­iffs caus­ing in­fla­tion goes some­thing like this. Trump has raised the cost of im­port­ing steel and alu­minium from over­seas. This raises the cost for man­u­fac­tur­ers in the US re­gard­less. They may start buy­ing their steel and alu­minium from US man­u­fac­tur­ers, the prin­ci­ple rea­son, but they are still pay­ing more for it. Those man­u­fac­tur­ers, whether they be Gen­eral Mo­tors or Boe­ing or the con­struc­tion in­dus­try op­er­ate on thin mar­gins. They have to pass this cost on as they can’t ab­sorb it and will make losses.

This pushes up the price of cars, air­craft and con­struc­tion costs and hey presto, we have in­fla­tion as well as lower de­mand as con­sumers buy less as prices rise. In ad­di­tion, those over­seas ex­port­ing coun­tries now suf­fer­ing tar­iffs will re­tal­i­ate with their own tar­iffs on US ex­ports. The net re­sult is slower global eco­nomic growth and ev­ery­body loses.

Nei­ther of these in­fla­tion va­ri­eties are com­ing from ex­cess con­sumer de­mand amid tight sup­ply in an eco­nomic boom.

They are both cost push in­fla­tion which is al­ways a func­tion of in­put prices and pro­duc­tion costs, in this case raw ma­te­rial costs and labour costs. The net re­sult is that in­ter­est rates are more likely to go up, bad news for bond mar­kets.

In ad­di­tion, the in­ter­est rate in­creases are not go­ing up to slow a boom­ing econ­omy. Trade tar­iffs and higher in­ter­est rates in­crease the costs for the global econ­omy and slow growth which un­der­mines eq­uity mar­kets.

Some jobs may tem­porar­ily re­turn to the rust belt of the US steel in­dus­try, but global de­mand will fall with eco­nomic weak­ness and those same jobs will even­tu­ally go any­way as the em­ployer has to cut costs as de­mand falls.

Bizarrely, if Trump fol­lows through with his tar­iffs and is suc­cess­ful in re­duc­ing the trade deficit with China and tem­porar­ily rein­vig­o­rates the US steel and alu­minium in­dus­try, it will be a pyrrhic vic­tory. In the process, he will have also re­duced US earn­ings of car man­u­fac­tur­ers, and the like, through re­duced profit mar­gins and/or caused prices to rise but also the US econ­omy will have suf­fered from re­tal­ia­tory tar­iffs. At the same time the FED will have had to raise in­ter­est rates more than they oth­er­wise would have done. Most economists are at a loss to ex­plain Trump’s logic but un­til this be­comes clearer it is un­likely the eq­uity mar­kets will make much fur­ther progress.

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