Wealth Insights  (November 2018)
Textbook Trade Troubles

Richard Jerram, Chief Economist, Bank of Singapore, Member of OCBC Wealth Panel

Rising concern over U.S. trade friction with China has been cited as a factor behind the recent increase in financial market volatility. This might simply be finding an explanation to fit the facts, as markets had previously been untroubled by intensifying trade tensions, but the issue is not going away. The large multinational firms that tend to be listed on the stock market are unavoidably more exposed to trade friction than the economy.

President Trump appears to think a country is losing if it is running a trade deficit. Regardless of the poor economic logic of this view, developments over the coming year are likely to show the U.S. as an even bigger “loser”. This gives a high risk of a continuation or intensification of trade friction.

The overheating U.S. economy is at the heart of the rising trade deficit. Fiscal stimulus is boosting demand in an economy facing capacity shortages, as shown by the unusually low unemployment rate. In a textbook response, some of that extra demand will be satisfied by increased imports, so the trade deficit will widen. This has already started and at some point, it should weigh on USD.

One positive aspect is that U.S. demand is helping to support growth in the rest of the world, which might help some emerging markets. However, this is offset by the risk that they come into the crosshairs of Trump’s trade policy.

China is clearly at the top of the list for U.S. tariffs, accounting for nearly half of the trade deficit. Next in line are Mexico, Japan and Germany, although the combined deficit with these three is around half of that with China. Friction with China seems qualitatively different, as it reflects a growing super-power rivalry, rather than a negotiation for more equal market access.

Mexico looks safe after the recently-updated NAFTA agreement. Rather than focussing on Japan or Germany specifically, it seems more likely that restraints on automobile imports address a large part of the imbalance (U.S auto imports are US$365bn compared to exports of US$161bn).

Tariffs on autos are currently under investigation and that could be disruptive for two reasons. First, Europe is likely to retaliate in kind. Second, it is hard to find substitutes, so the impact on U.S. prices will likely be significant. U.S. consumers paid the price of restrictions on Japanese car exports in the 1980s. In the case of tariffs on China, it is relatively easy to shift demand to, say, Vietnam or Mexico so overall U.S. import prices do not rise too much. However, if the result is negotiation, compromise and (eventually) more liberal trade then short-term pain could bring longer-term gain.

In theory, the Fed should not respond to a one-off change in the price level due to tariffs. However, in a hot economy it will be wary of knock-on effects pushing up underlying inflation. If price expectations rise, the Fed will be under pressure to tighten more aggressively.

Weak financial markets could persuade Trump to back away from further action on tariffs. However, he seems determined to try to pin any blame for volatile markets on the Federal Reserve, which could indicate an intention to persist. The probable rise in the U.S. trade deficit over the coming year – to record levels – will give him plenty of fuel to feed his discontent.

OCBC MoneyMonday™