Trade War – a Game of Chicken

In 1934 Congress passed the Reciprocal Tariff Act which essentially ceded to the President authority to negotiate tariffs with other countries. This bill was passed as the U.S. was exiting the Great Depression and Congress looked to reverse the disastrous Smoot-Hawley Tariff bill of 1930. (Further background on the Smoot-Hawley bill can be found in an earlier write-up here.) When drafting the Smoot-Hawley Tariff bill, the scope and size of the bill increased dramatically as many Congressmen added provisions to protect businesses in their home states. By passing the Reciprocal Tariff Act of 1934, Congress essentially acknowledged they were not capable of containing special interests and empowered the President with authority over tariffs.

President Trump has wielded these trade powers in a new and unpredictable manner. Investors are concerned that a trade war could bring higher inflation and a global economic slowdown. The trade issues began in March when President Trump announced tariffs on steel and aluminum imports with some countries like Mexico and Canada being exempted. The tariffs affected approximately $40 billion in imported goods. The Federal Reserve of Dallas estimates these tariffs could lower U.S. GDP by an inconsequential 0.24% as steel and aluminum imports account for a relatively small piece of the U.S. economy.

Since these tariffs were announced, the U.S. and China each threatened an additional $50 billion in tariffs and most recently escalated that threat to $200 billion in goods. In May, President Trump ordered a review of imported cars to the U.S. which is similar to the review he ordered for steel and aluminum. Car imports are sizable, totaling $179 billion annually. Tariffs on imported cars would spread the trade conflict to Japan and Germany and increase restrictions on Canada and Mexico. Given the size and importance of the car industry, retaliation is likely.

The effects of trade are complex as they create many winners and losers. While consumers benefit from inexpensive goods from China; trade with China has, objectively, not been fair. The Chinese government restricts foreign access to Chinese markets, provides direct subsidies to Chinese exporters, and suppresses the value of the Chinese Yuan by purchasing U.S. government debt – they own over $1.1 trillion. President Trump’s approach appeals to those in the U.S. whose pay and standard of living has fallen due to unfair trade.

While there is a lot of room for improvement on trade, a trade war could make matters worse for the U.S. in the long run. The Federal Reserve of Dallas estimates that a full blown trade war (which includes trade retaliation and includes the European Union and China) could cut 3.5% from U.S. economic growth. Essentially, a full-blown trade war could bring a recession. While recent rhetoric has made stock markets more volatile, recent declines are more reflective of uncertainty rather than a signal that investors expect a recession. President Trump knows he controls access to the world’s largest consumer driven economy and expects some concessions and more balanced trade. This game of chicken is risky and markets are reacting to the rhetoric on both sides. That said, markets still expect both countries will walk back their rhetoric and find some common ground.

Given the increased uncertainty, it is important for clients to stick to their long-term goals. Crestwood strives to manage diversified portfolios to help mitigate these market swings. Over the last few months, we have increased the quality of our bond portfolios and maintained an overweight to U.S. stocks, which have fared better than international markets during this public trade war posturing. We are confident that a continued focus on long-term goals and a diversified investment portfolio aligned with these goals are the keys to managing wealth in turbulent markets.

Trump’s Tariffs

On March 1st, 2018 President Trump announced his intention to impose significant tariffs on steel and aluminum imports. The announcement sent stock and bond prices falling, stoking fears of higher prices and slower economic growth. Protecting domestic industries like steel and aluminum may have raw appeal, but tariffs are flawed in theory and have a history of hurting economic growth. History shows a link between tariffs and populism which last flourished in the 1930’s. President Trump’s proposed tariffs threaten the post WWII global trade order and stock and bond markets are now paying attention.

Tariffs are bad policy

Basic economics instructs that tariffs benefit a select few producers and harm consumers through higher prices as they reduce competition and allow less efficient producers to continue to operate. In 1776, Adam Smith wrote of comparative advantage stating that countries should focus on their low cost production and trade for goods where their costs of production are relatively high. In general, society benefits from trade as wealth rises everywhere.

Tariffs have a consistent history of reducing economic activity and hurting growth1. The clearest example is the infamous Smoot Hawley Tariff Act of 1930, which essentially doubled tariffs on over 20,000 imported goods to an average rate over 50%. While this was one of many policy errors that contributed to the depth and length of the Great Depression, there is general agreement that these tariffs made matters worse. The effect of these tariffs on global trade are clear – from 1929 to 1933 world exports collapsed by roughly 55%. Continue reading