Trade wars just recently moved from rhetoric to reality. Some say this is one of many things that will make America great again, as President Trump moves full steam ahead to ‘level’ the playing field of tariffs. Others, including the well-respected World Bank, and 45 leading economists are giving severe warnings that this will lead to a full fledge recession. The questions get asked in many ways, many times; “What is the goal to this? How do we know we have reached this goal? Where is the definitive plan?
The Greatest Nations Will Have Trade Deficits, but What About Tariffs?
Whoever is the superpower of the world will have trade deficits. It goes with the territory. The trade deficit is a growing number, in 2017 it was at $375 Billion, which means we are importing much more than we are exporting in goods and services. President Trump wants the trade deficit lowered by at least $200 Billion.
This sounds good in theory, so I want you to think about this for a moment. America has been known in the past as “The Great Melting Pot”, (Stay with me, don’t tune me out because I AM NOT FOR OPEN BORDERS!), meaning people from around the world have come to America and made a life for them self, because America is the land of great opportunity.
We have four things here in the U.S. that the rest of the world doesn’t:
- Higher wages!
- A better lifestyle!
- More opportunities!
- A strong and higher currency!
Higher wages, and a higher currency is an absolute guarantee that our goods and services will cost more. This creates a trade deficit which has one benefit; foreigners are forced to buy our debt in the form of Treasuries. The realistic way to lower the Trade Deficit is to lower wages, lower our lifestyle, make our currency much lower, a second or third world type of currency. The other way is through government subsidizing all the areas like steel and aluminum, etc.
I don’t see any of those “fixes” ever happening. Instead tariffs, which is a tax, gets implemented.
President Trump first proposed tariffs in March to correct what he deemed were unfair trading practices with other countries, a trade deficit of $375 Billion annually. Most of this has to do with China, yet President Trump didn’t stop there. He continued with Canada, the European Union (EU), and Mexico. President Trump has escalated to a stance more on the offense. The first tariffs were put on steel and aluminum. Specifically, he has called for several tariffs to be put into place for “National Security reasons”. Justin Trudeau, Prime Minister of Canada, responded after the implementation of these tariffs on Canada. He asked how Canada, one of America’s most stalwart allies could be a National Security threat to the United States. President Trump jokingly responded by asking, “Didn’t you guys burn down the White House?” This was supposed to be a reference to the War of 1812 and would have been a pretty good retort—except that it was the British who torched Washington. What most people might not realize is that according to U.S. law, the President can’t just input tariffs, unless it is deemed a national security threat. Thus, the reason for using this type of verbiage.
The top steel supplier to the U.S. in 2017 was Canada, followed in order by: Brazil, South Korea, Mexico and Russia, Turkey, Japan, and Taiwan. China is on the list as number 11, meaning 10 other countries import more steel to the U.S. than China. Last year the U.S. imported steel from more than 100 other countries. Three quarters of the imported steel came from just eight countries, according to the International Trade Organization. How come we only put tariffs on China, Canada, and Mexico then? Canada responded with equivalent tariffs on U.S. products which include: orange juice, yogurt, whiskey, maple syrup, and soups. Almost all U.S. tariffs have been met with the imposed upon country retaliating at the same level or more, putting tariffs on U.S. imports.
According to the Office of the U.S. Trade Representative (the U.S. government’s report on trade) we don’t have a Trade Deficit with Canada, rather we have a Trade Surplus of $8.4 Billion in 2017.
The Markets Are Spooked
The U.S. is officially in the largest trade war in its countries history. The previous largest trade war was in 1930. Experts have pointed to the failure of the Smoot Hawley Tariff Act as having prolonged The Great Depression. The markets are showing signs of weakness due to growing uncertainty, but well-respected people have said it is working. Mohamed El-Erian, Chief Economic Advisor at Allianz, told CNBC that the U.S. is winning the trade war. “In relative terms, we are winning, and we will win the trade war,” “Just look at the performance of U.S. markets relative to China and reative to others.” Year to date the Dow is up 1% while the Shanghai Stock Exchange is down 16%.
That picture is very misleading though, since the Chinese economy has already experienced tremendous expansion. Before trade tensions, their economy was contracting, while the U.S. economy was and is still expanding, but most believe the U.S. is near the end of this cycle. Meanwhile, investors have been on edge amid the trade tensions. The market says there is a 30% chance of a severe trade war and 70% chance of a very modest skirmish.
Many well-respected analysts are just as passionate in their current assessments, which are directly opposite of El-Erian’s statements. Their voices are by far, more numerous than the few in the camp of El-Erian. Take a look at just this last week in which there is a small sample of highly respected analysts and investors and what they are saying.
- Scott Minerd, head of Guggenheim Partners, recently said on Bloomberg News, “That hail of risk is just getting fatter and fatter as we go along. So far the Chinese have shown no interest in backing down and neither has Donald Trump”.
- Paul Donovan from UBS also said, “I don’t think we need to be hitting the panic button quite yet, but we have moved a lot closer to it, there is no question.”
- Ben Simpfendorfer, from Silk Road Associates, said “Until we see some compromise on the Chinese side, but also the U.S. side, there is a real concern it will only get worse from here.”
- Mark Mobius, from Mobius Capital Investments, “The whole situation with China and the U.S. is very critical, particularly for China. I believe the situation is getting worse. Trump is not going to give in.”
- Bank of Canada Governor, Stephen Poloz said “In our discussions the biggest issue on the table was trade tensions. Given the multiple channels through which protections measures and effect economies, it should be clear that monetary policy is ill-suited to counteract all of their effects.”
- Alex McKnight from GAM said “If you worry about this renewed volatility that we have seen because volatility again has been reborn. Then you need to worry about your underlining credit exposures as well.”
- Jim Millstein of Millstein & Co. said “It seems like a perfect storm. Creating conditions where recession is very likely, and the increases incidents of defaults and delinquencies are higher.”
Put this into perspective that this is only a snippet sample of one week.
Early Signs Tariffs Are Hurting US
Theses text book explanations show that historically, trade tensions or trade tariffs attacks are inflationary and can trigger a recession. Although we are still in the early stages of a trade war, we are starting to see inflationary examples confirming once again, that tariffs are inflationary. We have seen assets cost more due to Tariffs. Such is the case with washing machines coming from china which have risen 20%. However, the ability to impact business and consumer sentiment is high, while the after effect is a business slow down. China has hit back hard, targeting President Trump’s base by also making this a political war. Soybean farmers are taking the brunt of this since China put a 25% tariff on U.S. soybeans on April 4th of this year. The American Soybean Association expressed its extreme frustration about the escalation of a trade war with the largest customer of U.S. soybeans.
In a prepared statement, the American Soybean Association (ASA) called on the White House in mid-April to reconsider the tariffs that led to this retaliation. China purchases 61% of the total U.S. soybean exports, more than 30% of overall U.S. soybean production. “It should surprise no one that China immediately retaliated against our most important exports, including soybeans. We have been warning the administration and members of Congress that this would happen since the prospect for tariffs was raised. That unfortunately doesn’t lend any comfort to the hundreds of thousand of soybean farmers who will be affected by these tariffs. This is no longer a hypothetical, and a 25 % tariff on U.S. soybeans into China will have devastating effects on every soybean farmer in America,” said ASA President and Iowa farmer John Heisdorffer. Shortly after China’s announcement, soybean futures dropped 40 cents a bushel. “At a projected 2018 crop of 4.3 billion bushels, soybean farmers lost $1.72 billion in value for our crop this morning alone. That’s real money lost for farmers, and it is entirely preventable,” Heisdorffer said.
As time has gone on the news only gets worse for the U.S. soybean farmer. Already soybeans have dropped 65% from its previous high in late 2012 to the level it was before tariffs were put into place. This drop was due to the slowdown in the Chinese economy. In June this year The World Agriculture Supply and Demand Estimates (WASDE), a monthly report on agricultural products, shows year to date that soybean exports have dropped 51% this year down 11% just in June.
This is because China has now started buying their soybeans from Brazil. The price of Soybeans has dropped 31.1% since March, when the U.S. first initiated tariffs against China. No farmer can survive with that type of drop. I would think that all U.S. soybean farmers would significantly disagree with Mohammed El-Erian in his statement that, “[The U.S. is] winning this tariff war.”
Another thing that relates to a business slowdown is the Fed. The Fed is raising short term rates while long term rates are not rising. There is a massive difference of opinions between the Long and Short positions in the Treasury markets. You can see a huge divergence between the Real Money Longs and the Speculative Shorts that has reached the widest gap since leading back up to the last financial crisis.
The supply demand in the Treasury markets are going to drive short term yields higher. The Fed is reducing their balance sheet, another $200 Billion the rest of the year. Our largest sovereign buyers are buying less, while banks are also holding less. This is due to less regulations of money on deposits. This is all pointing to shorter term Treasury yields moving higher and causing an inversion in the yield curve, which 9 times out of 10 has caused a recession.
In the last 5 years, 69 U.S. traded companies have increased their debt by over 50%. This has happened while the quality of leveraged loans has deteriorated.
China is facing a credit crunch, having the largest number of bad loans. The Chinese government is trying to figure out how to get through this.
The trade war is causing rippling effects, pushing the Dow down through the 200-day moving average, a major support level. This fact is critical and could be the one to watch more than any other fact. Also, prices in many commodities such as, soybeans, oil, and metals have moved slightly lower.
Tariffs Affecting Technology?
The U.S. is threatening to impose a 10% tariff on $200 Billion of Chinese-made products. The list so far is refrigerators, freezers, air conditioning machines, apparels like leather goods, televisions, stereo components, and electric vehicle batteries.
So far the one tech product that avoided tariffs is the iPhone. Apple, a company that creates its technology out of California, yet produces the iPhone in China, has not been in the tariff list so far. Apple CEO Tim Cook and President Trump have met many times. Mr. Cook has said multiple times that tariffs are not the way to reduce our trade deficit. China could slap retaliatory tariffs on Apple sales in China. Moving forward, tech is now in the crosshairs of the trade war. If put into effect, one would assume tech stocks would be adversely affected, which could negatively impact or even stop the recent rally in tech stocks.
Last week Tesla made a major announcement. Tesla is expanding their footprint in China. They are following in the footsteps of Harley Davidson, by moving manufacturing to another country because of tariffs and production costs. How does that help make America great? Tesla will become the first foreign automaker to open a wholly owned factory in China and forgo a joint venture arrangement. Tesla, the electric car maker, is planning to build a plant that would manufacture 500,000 vehicles a year. This would be a huge blow to President Trump’s trade campaign against China. Tesla follows Harley Davidsons chartered plan by moving some of its manufacturing outside the United States to avoid existing tariffs and future escalating trade disputes. China embraces this deal since they are light years ahead of the U.S. in the electrical car industry. By year 2030 China wants to be all electric. At some point China will move past the U.S. in car production. Tesla has learned and is following the example from General Motors by creating a large auto manufacturing facility in the fastest growing automobile market in the world, being China.
Short Term vs. Long Term
The tax cut was like pouring kerosene on a fire, yet that has now been factored in. Many analysts say our trade policies being put into place do not have a definitive goal and will be the catalyst to a recession. Because of the tax cut it has deepened our countries debt structure, escalating our budget deficit to over $1 Trillion next year. In addition, Trillions of dollars will be added to the national debt. As rates go up, servicing that debt becomes burdensome. Higher rates will contribute, if not cause, an inversion in the yield curve meaning longer term rates would be lower than shorter term rates. We don’t have the fiscal arsenal to inject into the economy. We have long term financial structural problems that within the next 2 years will come to the forefront of short term cataclysmic structural problems.
The numbers are not showing that tariffs are having a broad negative effect on the growth of the economy yet. Neither is it showing any benefits in any sector. However, confidence is now showing signs of weaning since trade wars are now in effect. If these continue for some time or more tariffs go into effect, confidence could be lost since this all gets passed off to the consumer through price increases.
Most of President Trump’s message on this started during his campaign. He was very effective in getting voter support for this cause. The great news is he is following through with what he campaigned on. His base is happy and believes this will benefit them eventually. Now that we are in the midst of a trade war, a portion of President Trump’s base, as well as others are now questioning the process. When you study history and look at the numbers, there has never been a time where tariffs had short-term or long-term benefits, only uncertainty.
This Time is Different
Are you willing to just trust our government to get this right, simply because people are saying that this time, this will be different?! Yes, so far that is a true statement. This time we have broken the long standing global supply chains. This time we have alienated most of our allies. This time we are going into this trade war at the end of the economic cycle with high personal, corporate, and government debt, when debt levels should be minimal, not at historic highs. This time it is happening when foreigners are not buying our debt, rather they are selling our debt, U.S. Treasuries. This time it is happening when our own bank, The Federal Reserve, is also massively selling our own currency, Treasuries. Has China been preparing for this and patiently waiting all along? If one studies China’s behavior and activities in the past decade, they would see a method to the apparent madness. China thinks in terms of decades to dynasties, and the U.S. thinks more in the moment, maybe this time just might not be…the right time. If this makes any sense and you see problems on the horizon, then this time is the right time, to buy Gold!