All things trade: USMCA and scenarios for negotiations with China
Trade tensions are abating in most parts of the world, but U.S.-China negotiations could get worse before they get better. In this post, we explore scenarios for global trade and their investment implications. For additional information, reference the previous posts on trade brinkmanship and how to determine when a trade war will impact U.S. and international markets.
On September 30, Canada and the U.S. agreed to replace NAFTA with a new trade deal called USMCA (United States–Mexico–Canada Agreement). Passage of the agreement is not assured, and the overall impact of the agreement on economic growth is not yet scored. However, where tariffs and supply chains in North America are concerned, this progress is good news.
USMCA: The basics
Changes to the trade relationship between the U.S., Canada, and Mexico are relatively minor. U.S. dairy producers will gain access to 3.5% of Canada’s heavily protected dairy market. The agreement also achieves modest increases in labor standards, local content requirements in the automotive sector, increased intellectual property protection, and new financial services rules. That said, the most urgent benefits that the agreement achieves are what it avoids – steel and aluminum tariffs and auto restrictions in North American supply chains.
USMCA and the recent agreement with South Korea show that the Trump Administration is willing to step back from protectionist policies in exchange for concessions that allow negotiations to be labeled a political win. Japan and the EU are certainly taking note of these strategies.
Negotiations with China are likely to be harder
However, we think negotiations with China are likely to be different for a few reasons. First, the U.S. trade deficit with China is nearly half of its total trade deficit, and much larger than that with its other trading partners. Second, Trump quickly pulled back from the trade deal initially brokered by Treasury Secretary Mnuchin in May. Third, Trump has broader domestic support for adjustments to trade policy with China, including support from congressional representatives in both parties. As a result, we think that U.S. trade negotiations with China will likely get worse before they get better.
Where are we now?
The U.S. has imposed tariffs on $250 billion (USD) of Chinese goods. The Trump administration has threatened tariffs on another $267 billion of goods which, if imposed, amount to approximately all of U.S. goods imports from China.
China has retaliated by imposing tariffs on $60 billion of U.S. goods, and by targeting businesses in the electoral base of Republican leadership. China has also invited key U.S. business leaders to discuss potential for continued business cooperation and has signaled a willingness to reduce tariffs across the board.
Otherwise, negotiations are at a stalemate. But, while surveys increasingly cite concerns over unanticipated trade costs, economic data do not show a meaningful impact of trade measures imposed to date. Durable goods and advance goods trade are stable, and business and consumer confidence are high. What’s more, fiscal stimulus in the U.S. has provided support that exceeds the impact of tariffs.
Estimates impact of policy ($B)
Source: NYLIM, SAS, Bureau of Economic Analysis (BEA), Strategas, Cornerstone Macro Research. Data as of 9/24/18. Opinions of New York Life Investment Management Strategic Asset Allocation and Solutions. The information is for informational purposes only and is accurate as of the date submitted, but is subject to change. *25% tariff rate used for this estimate.
Scenarios for trade with China
Where, then, do we go from here? Both the U.S. and China stand to lose from heightened tensions. The U.S. is a large and diversified economy, relatively shielded from impacts to trade. However, the economy is near the end of an economic cycle, and a major disruption could prompt trouble for financial markets. In addition, the outperformance of the U.S. stock market has provided support for the Trump administration, meaning that a markets disruption could impact U.S. politics.
Meanwhile, China has been very carefully managing an economic transition from a manufacturing-based to a service-based economy. Disruptions to China’s export economy could prove challenging and prompt a faster-than-expected slowdown.
Given tariffs already imposed, a short-term truce is increasingly unlikely. We thus see three potential scenarios for trade negotiations:
Trade Scenario 1: Both sides back down
Given the tariffs already imposed, it is unlikely that trade negotiations between the U.S. and China fizzle out any time soon. However, if the Trump administration faced declining support for protectionist trade policies – either because the economic impacts of tariffs become too strong or because his political capital collapses – then it could dial back its threats.
One of the reasons why this scenario is unlikely is the fact that the economic impacts of tariffs take hold at a lag. It takes several months for higher input prices for companies to work their way to consumer pocketbooks or company profit margins. However, a swift financial markets reaction to negative trade news could also prompt a more conciliatory tone from the U.S.
Trade Scenario 2: China blinks
As the year has progressed, Trump has proven willing to impose the tariffs that he threatens. In a way, this gives trade negotiators on both sides more leverage because the understand the extent of possibilities facing them. President Xi Jinping has defended the existing global trade order, and may have learned from Europe, Mexico, and Canada that letting Trump “win” does the most good for all parties involved. In the best-case scenario for the U.S., China would back down on technology issues and open its market to more American goods and services.
Trade Scenario 3: All-out, prolonged trade war
Both sides have a lot to lose, and neither side wants to be seen as weak. President Trump gained power in the U.S. in part due to his appeal to rust belt states impacted by globalization. This puts some pressure on the administration to maintain its hardline stance against China. However, putting pressure on China to changes its economic model – rather than keeping pressure focused on trade activity – could backfire. In this worst case scenario, both sides dig in their heels, imposing tit-for-tat tariff and non-tariff barriers on an increasing span of goods and services.
If tariffs prove ineffective in changing China’s business policies, the Trump administration could apply additional pressure to cripple China’s access to global markets. Financial, investment, and travel restrictions on Chinese officials and businesses could quicken the country’s economic slowdown and threaten greater escalation.
For a trade war to have major economic impact, it would not only need to escalate but also to be sustained. Companies are unlikely to disrupt long-standing supply chains over an increase in prices, especially if that increase is offset by the benefits currency depreciation or fiscal stimulus. However, a steady increase and maintenance of tariffs would move to business and consumer confidence and could bring an early end to the U.S. economic cycle.
The trade dynamic is unlikely to unfold in a linear way. Trade developments will impact markets when they change expectations for:
- Economic growth, via slower imports/exports and reduced business activity as companies re-think supply chains
- Inflation, via higher inputs prices
- Relative performance between countries
These expectations can be complex and even conflict. For example, weaker economic growth can prompt lower inflation, lower interest rates, and thus currency depreciation to balance some of the negative impact of tariffs. However, the tariffs themselves can also contribute to higher inflation, obscuring potential financial markets impacts.
Speaking in general terms, heightened trade barriers would prompt lower economic growth, business disruption, and higher inflation. Multinational companies are disproportionately affected, increasing the appeal of domestically-oriented small caps. Emerging markets in particularly are likely to experience trouble as their supply chains and currencies are disproportionately impacted by global trade. Business investment would likely stabilize or decline as companies take a “wait and see” approach to tariff measures.
By contrast, good news on trade improves economic expectations. Global supply chains are preserved, reducing the appeal of domestically oriented small caps. Emerging and international markets would be more likely to close the gap in equity performance that has widened throughout 2018.
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The North American Free Trade Agreement (NAFTA) is an agreement among the United States, Canada and Mexico designed to remove tariff barriers between the three countries.
The United States–Mexico–Canada Agreement (USMCA) is a pending free trade agreement between Canada, Mexico, and the United States. It is also referred to as “NAFTA 2.0”, in order to distinguish it from its intended current predecessor North American Free Trade Agreement.
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