Don’t Fear the Latest Trade Disputes

Make no mistake: Free trade has been a positive for U.S. economic growth. In the past 15 years, it has led to a near-doubling of manufacturing profits, a decline in consumer inflation and lower interest rates.  In contrast, tariffs act as a tax on consumers and have low a likelihood of creating new jobs. 

Now that protectionist rhetoric is heating up, markets are reacting and volatility has increased.

That doesn’t mean investors should panic. Political rhetoric has been worrisome (and misguided, I would say), but I think the ultimate economic impact of new tariffs will be smaller than feared. I expect China will negotiate with the U.S., but won’t yield much ground. The economic rationale for compromise is high for both sides. 

The Trump administration’s beef with China seems to have more to do with politics and protecting U.S. intellectual property than trade imbalances. China’s import growth has boomed in recent years (with the benefit accruing, not to the U.S., but to Germany, Japan and emerging market economies). Contrary to persistent complaints that China is keeping its currency artificially low, the government has allowed its real exchange rate to appreciate by more than 30% since 2007. 

The real problem seems to be that China is now moving into high tech and could eventually create companies that rival strategically important defense-linked industries like semiconductors, big data and artificial intelligence. Ultimately, I think these disputes are about slowing China’s march to economic global dominance.

U.S. efforts may not be that successful. China isn’t that reliant on exports to the U.S., but U.S. companies are eager to expand into gradually liberalizing Chinese markets in industries like health care, media, education and financial services. China is also the largest non-U.S. holder of U.S. Treasury securities, another card it holds. If it shifts its reserve policy, U.S. interest rates (and debt servicing costs) could rise.

I expect Chinese leaders to make some concessions to the U.S. for public perception reasons, but not to diverge from their long-term goal of building national champions in strategic high-tech industries.

Rather than retreat, I suggest investors try to exploit volatility associated with trade risks. Most globally traded goods have substitutes and Trump administration rhetoric may create opportunities for multinationals headquartered in Europe, Japan or emerging markets.

Escalating trade tension isn’t a plus for the U.S. economy. It’s bad for CEO confidence and could put a chill on capital spending, which was starting to pick up. It could lead to higher inflation since import prices would rise and it makes U.S. Treasuries less attractive to investors at a time when debt issuance is climbing.  But China holds most of the cards in this game. That means dramatic change in trade policy and structural dislocation in global markets is unlikely.