SINGAPORE (July 30): Amid rumblings of a potential full-blown trade war, it is important to understand why the current US administration has opted for this path, which in some states in the country is seen as politically attractive. 

The US current account deficit in 2017 was US$462 billion ($631.7 billion), the largest in the world. The main cause of this is its US$566 billion trade deficit. Interestingly, the world’s largest surplus economies in 2017 were the European Union with US$387.1 billion and China with US$162.5 billion. Hence the current attacks on the EU and China by the US administration.

In order to sustain its economy and its twin deficits, the US has to borrow money. (It also has a budget deficit that is likely to balloon this year and next, given its generous tax cuts.) The US funds its deficits by issuing US Treasury notes. As the federal government guarantees the Treasury notes, they are viewed by investors as the safest in the world. The largest owner of US Treasuries is the nation’s Social Security Trust Fund and the largest foreign owner is China. 

No surprise then, that in the mind of current US President Donald Trump, China and the EU are its trade adversaries. And that perception is unlikely to change. 

Stefan Hofer, managing director and chief investment strategist at LGT Bank HK, says one of the results of faster US GDP growth may be a higher trade deficit. 

“At a 3% rate, the US economy is growing well above trend, given that many economists assume potential GDP in the US is around 2%. While these numbers may not seem significant at first glance, it is worthwhile bearing in mind that at an aggregate GDP size of US$20 trillion, ‘above trend’ growth for the US has a widespread, powerful impact on the global economy,” Hofer notes. “As the economy grows and US households receive tax cuts under the 2017 tax reform, invariably, some of this windfall is saved and, inevitably, a portion is directed towards imports. As such, while the Trump administration seeks to narrow the overall trade deficit, it is probable that the fiscal easing may keep the trade deficit high or close to current levels.”

One of the most tangible effects of increased US tariffs on imports is on domestic prices for consumers. “Indeed, in February, new tariffs were placed on a number of goods, such as solar panels and washing machines. Between 2013 and mid-2018, washing machine prices in the US were on a consistent downtrend,” Hofer says (see Chart 1).  

“According to the Bureau of Labor Statistics, prices as per May and June 2018 jumped substantially — tariffs are the likely driver behind this increase, and hence it can be argued that US consumers are now worse off as a result,” he says. “In the short run, tariffs are unlikely to cause a sudden increase in domestic US washing machine production; therefore, those consumers who ‘must’ buy these appliances will do so at higher prices.”  

If the washing machine example is multiplied across a wide range of goods, Trump’s approval rating could come under pressure, especially because his support base comprises low-income Americans whose purchasing power will be eroded by these tariffs, Hofer reasons. 

“What is interesting to note is that while the US corporate sector — and, most recently, the US Federal Reserve as well — has started to voice concerns over the imposition of tariffs, President Trump’s approval rating remains high.  As such, it appears that price levels have not increased to a point that they bear a political cost,” he notes. “The turning point could be the November US mid-term elections; if the CPI (Consumer Price Index) accelerates soon, then the administration may come under pressure to tone down or even reverse course on its hawkish trade policy. If prices only jump after the mid-term elections, then it may take much longer for the de-escalation of the current trade disputes.”

Trump has threatened a 10% tariff on a further US$200 billion of Chinese imports. His initial 25% tariff on US$34 billion of Chinese imports was met with a retaliatory tariff by China.

Gunboat diplomacy and collateral damage 

Hofer likens the Trump administration’s strategy to gunboat diplomacy. In the 19th century, the British would send in the navy and just by a show of force, countries would acquiesce to its demands. 

So what of China? What options does the country have to avert a full trade war? Hofer does not think it will announce a “buyer’s strike” and not buy US Treasuries because that would cause the valuation of its existing holdings to fall, and would be a self-defeating strategy.

Competitive currency devaluation is another matter. On July 21, Trump in a tweetstorm accused China and the EU of “manipulating their currencies and interest rates lower”.

Beyond the US, the current market dynamic has had a far-reaching impact across Asia, Latin America and emerging Europe. In particular, the high US growth rate, rising dollar interest rates — and potentially also the tariffs — have ushered in a strong US dollar.  The drop in currencies such as the Indonesian rupiah (despite a concerted interest rate defence by the central bank), Argentine peso and Turkish lira are very notable, Hofer indicates. 

In terms of China, the authorities have implied that they will not engage in a competitive devaluation of the renminbi to counter US tariffs. “That said, since April 2018, the Chinese yuan is down 8.5% against the US dollar, prompting complaints from the US government over ‘illegal currency manipulation’. As a potential harbinger of further ­US-China tensions, currency movements will likely be watched by all sides over the coming months,” Hofer says. 

One of the things the US is investigating is tariffs on cars and car parts. Cars imported into the US from the EU face an import tariff of 2.5%; cars exported from the US to Europe face a 10% import tariff, Hofer indicates. “As such, there are some imbalances on a range of goods. However, the average weighted tariffs on EU-US trade are essentially the same. In aggregate, it is hard to claim that the US is at a material disadvantage. This topic will likely remain a heated debate over the months ahead, especially given the risk of US tariffs on new vehicles and car parts, which would likely have a damaging impact on European growth and employment,” he says. “In terms of ­de-escalation scenarios, one possibility is that US trading partners will respond by offering a ‘zero tariff’ regime.” On July 25, the EU and US declared a truce and agreed to discuss eliminating trans-atlantic trade barriers on industrial goods.   

In Asia, many countries in the region are caught in the crossfire over US-China trade and tariffs (see Chart 2). Hofer point outs that 50% to 60% of imports from South Korea and Taiwan to China are electronic products (see Chart 3). “Both South Korea and Taiwan export a significant amount of electronic components to China for final assembly, before those finished products are sent to end markets. As US tariffs are applied to those ‘made in China’ items, the effects will likely be felt in supplier economies as well,” he says. 

Hofer warns that Singapore will be affected as well. “Singapore, with a very high share of trade as a percentage of GDP, is unlikely to escape unscathed. As a regional trading hub, lower shipping volumes will likely leave their mark, even though the new tariffs are not being targeted against Singapore itself,” he explains.  

Interest rates continue to rise 

There are many examples of such “innocent bystander” type effects. For example, cars assembled in the US by German firms are now facing the same tariffs as US firms, given retaliatory tariffs by China. 

To date, about 20% of companies in the Standard & Poor’s 500 Index have reported first-half earnings, and their earnings growth of 21% has been above expectations. Hofer expects earnings growth to continue in the same vein for most of the S&P 500 component stocks. 

This, coupled with almost full employment and a “pro-cyclical” push from tax cuts and tariffs, could cause inflation to rise ahead of expectations. Even without the tariffs, inflation was rising with full employment and high energy prices. 

How will the Fed respond to these inflationary pressures? Would it raise rates faster than anticipated? Some economists are expecting four rate hikes by the end of the year, and a further four next year. Or, does the Fed recognise that tariff-led inflation is not “real” and will stay its hand? 

“Another ‘innocent bystander’ given on­going trade disputes is the US Federal Reserve, and the prospect for further interest rate rises. Trade disruptions pose downside risks to growth and upside potential for inflation. As such, should the Fed pause and assess the drag on growth, or should it proceed to normalise monetary conditions given full employment and inflationary pressures? In short, the reaction function of the Fed will likely become more complex over the coming months and this, in turn, could heighten market volatility,” Hofer says. 

Cooler heads to prevail

He, along with global investors, is hoping that the US and China will eventually come to a pragmatic arrangement. “In terms of the next steps, financial markets are watching closely whether the US will apply 10% tariffs on an additional US$200 billion of Chinese imports, and then gauge the reaction from Beijing. All told, it promises to be an active summer, with investors dynamically pricing and repricing risky assets as events unfold.”