Key Points

• US tariffs on China have resulted in higher import prices in the US and some lift in consumer prices. Further potential US tariffs on Chinese imports will hit US consumer goods prices and could add around 0.3% to annual inflation.
  
• The US economy remains in good shape, despite fears of a recession. But the trade dispute is playing a role in weakening business confidence and investment plans.
  
• Investor expectations for an improvement in global GDP in the second half of 2019 could be disappointed. World trade volumes continue to fall and a further escalation in the trade dispute risks could detract from global GDP growth.

Introduction

Trade disputes create more losers than winners. The uncertainty created tends to hurt business confidence (and investment) and prices for businesses and consumers usually rise. Disruptions to supply chains can also dent productivity. Import-competing businesses in the tariff-levying country could benefit via higher employment and profits if demand shifts to these domestic producers. But these benefits tend to be erased by an appreciation in the currency which usually happens once tariffs go in place.

Given that the US/China trade dispute has been ongoing for more than a year there is enough data to analyse its impact. In this Econosights we measure the impact of the trade dispute on the US and global economy.

Some background to the trade dispute

The timeline of tariffs and goods that have been affected are:

• January 2018: US tariffs that range from 20%-50% on solar panels and washing machines.
• March 2018: US 25% tariff on steel and 10% on aluminium for all suppliers (not just China but a lot of the major trading partners were excluded). China retaliates with various tariffs on US agricultural exports.
• July – August 2018: US 25% tariffs on $50bn worth of Chinese goods, mainly for intermediate goods. China retaliates with 25% tariff on $50bn of mainly US agricultural exports and also some commodities.
• September 2018: US 10% tariff on $200bn worth of Chinese goods, also on agricultural and intermediate goods, fabrics and chemicals and some electronics. China retaliates with various tariffs (which average at 7.5%) on $60bn worth of US exports – mainly on agricultural goods, chemicals and machinery.
• May 2019: US tariffs on $200bn worth of goods now increases to 25%. China retaliates with tariffs on existing $60bn worth of goods with an additional average 7.5% increase in tariffs.
• May 2019: President Trump threatens to put 25% tariff on remaining $300bn of Chinese imports (mainly consumer goods). No news yet from China on retaliation.

All together the tariffs on Chinese imports that have gone ahead make up around 10% of total US imports. But, if the additional tariffs on Chinese imports went ahead, it would mean 20% of total US imports are impacted which is significant. Chinese tariffs on the US make up around 8% of US exports.

The impact of tariffs on prices

US tariffs on Chinese goods mean that US importers who import these goods pay the tariff levy (or tax) to the US government and the government budget benefits via higher revenue. Higher costs for the importers are then passed down supply chain to: businesses who use imported products in their own production, manufacturing firms who transform the goods into another product and consumers who directly use the goods.

In theory, higher costs of Chinese imports mean that consumer demand falls for these goods and shifts to either cheaper imports from another country or a domestic source. While trade tariffs are often cited as a mechanism to protect domestic industries, this only occurs if consumer demand goes to the domestic producers. What usually also happens is an appreciation in the currency of the tariff-levying nation which makes imports cheaper, increasing imports and exports more expensive, decreasing exports so this often erodes the benefits of protecting domestic industries.

Chinese exporters can respond in a few ways. To stay competitive, Chinese exporters may decrease the price of their goods and absorb the cost of the tariff (although history shows that exporters rarely cut prices). The trade supply chain also tends to adjust. China may divert its previous exports headed to the US to another country or Chinese firms may set up operations in another country and continue exporting to the US to avoid tariffs. But these changes are unlikely to occur quickly, given high costs of these changes.

The chart below shows changes in import prices since January 2018 (when the trade conflict started). Prices for steelmaking imports had a large lift in prices over the year, which reflects the tariffs on steel and higher iron ore prices. Sectors impacted by tariffs on intermediate goods, like industrial supplies and building materials also show some lift in prices around mid-2018 (when tariffs were hiked noticeably), especially compared to the flat growth in average import and consumer prices. Despite further tariffs imposed towards the end of 2018, import prices steadied in the second half of the year, an impact of the stronger US dollar (it appreciated by around 4% in 2018). As noted earlier, currency appreciation tends to erase the benefits to domestic industries as imports become cheaper.

US consumer prices also lifted on tariff hikes, but the impact was more muted. US consumer price inflation (ex energy) is currently running at 2%, which is basically unchanged on a year ago.

The chart below tracks consumer prices in various sectors since January 2018 but shows fairly muted increases in consumer prices, apart from appliance prices, which reflects the tariffs on washing machines.

Recent research from economists Flaanen, Hortacsu and Tintelnot in 2019 actually found that tariffs on washing machines increased prices of imported consumer goods but also allowed domestic producers to raise their prices, along with complementary goods (like clothes dryers), as the two items are often bough together. We estimate that potential tariffs on consumer goods imports will have a direct impact on consumer prices and could add around 0.3% to annual inflation.

Will the trade war send the US into a recession?

Concerns of a near-term US recession are premature. US consumers are benefitting from a low unemployment rate and some pick up in wages. Corporate earnings have been revised lower, but are still healthy. But business confidence weakened over 2018, business investment growth is stalling, manufacturing PMI’s are still falling and consumer confidence is mixed across the various surveys. Uncertainty created by the trade dispute is cited in business surveys as a risk, so the danger is that business spending weakens and jobs growth declines. US export growth has slowed over recent months which reflects the weakening in global growth but is also a sign of the trade dispute hitting demand for US exports.

While we see only a slight chance of the trade dispute on its own as being enough of a catalyst to drive the US into a near-term recession, US economic growth may drop to around 2% year on year (the US economy is expected to expand by 2.3% in 2019) if the trade dispute continues.

The impact on Australia & the global economy

The impact on Australia from the trade dispute is via reduced demand for exports from lower growth in China, especially Chinese demand for iron ore, which is an input into steel (a Chinese export that has been hit with higher tariffs). An escalation in the trade dispute could mean that the Reserve Bank of Australia will need to cut interest rates below 1% this year.

Global trade volumes weakened noticeably in the second half of the year and continue to remain low (see chart below). Exports in the US and China have been soft over the past few months. Low growth in the Eurozone is also contributing to poor global export growth but the trade dispute is adding to this weakness. The recent US manufacturing PMI survey, for example, cited trade as a key concern for purchasing managers.

We estimate that the drag on the global economy from the trade dispute has detracted around 0.1-0.2% from world GDP so far, from disrupted trade channels and higher costs. Current forecasts of world GDP for around 3.3% this year are at risk of being downgraded to around 3% if the trade dispute escalates.

Implications for investors

Investors are anticipating an improvement in global GDP in the second half of 2019, especially as Chinese policy makers have been doing more monetary and fiscal stimulus. But, economic data is yet to show signs of this upturn in the global economy. And further escalation in the US/China trade dispute will hit world GDP growth this year. The resumption of a trade war between the US/Europe is also another risk to keep in mind. In this environment of trade uncertainty, declining world trade volumes and weakening manufacturing PMI’s, share markets are expected to remain under pressure in the short term, especially in markets like the US where prices have run up hard since the beginning of the year.