US trade policy risks look under-appreciated

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We track the increase in international tension over US trade policy and the EU and Chinese responses and explain the objectives, while adding in the implications for (Treasury) fixed-income investors.

Challenging international trade norms

Having passed its tax measures in December and February, the US administration’s focus has shifted towards the implementation of “America First” measures on international trade (and immigration).

While many analysts had dismissed the Trump administration’s tough talk on trade as a negotiation tactic, we took the rhetoric at face value. The administration has for some time been engaged in a steady process of challenging international trade norms and renegotiating trade agreements, with the goal of reducing the US trade deficit and revitalising the US manufacturing sector. Renegotiating the North American Free Trade Agreement (NAFTA) with Canada and Mexico started fairly quickly last year, but investors may have seen the delay in tariff measures as indicative of the administration’s bark being worse than its bite.

In reality, though, the administration has been following a defined legal process so that it could use specific authorities granted to the president under the Trade Act of 1974 and the Trade Expansion Act of 1962. Only in recent months has that process progressed to the stage of decision-making.

A wave of trade policy moves

Since our April commentary, the US administration has undertaken the following:

  • May: the Trump administration launched another Section 232 review of EU automobile imports into the US. It threatened to place a 20% import tariff on all vehicles assembled in the EU if the EU did not reduce its own import tariffs. The European Commission responded by threatening retaliatory tariffs on almost USD 300 billion of US exports.
  • June: the US cancelled initial waivers and imposed tariffs on steel and aluminium imports from Canada, Mexico and the EU under the guise of a Section 232 finding which alleged damage to national security interests. Both trading partners announced the imposition of retaliatory import duties on a range of US goods. EU duties took effect on 1 July.
  • June: discussions on amendments to the NAFTA deal broke down at the last minute as Canada and Mexico objected to a ‘sunset’ clause.
  • Late June: the G7 meeting in Charlevoix, Canada, closed with the US president withdrawing support at the last minute for the communiqué that the G7 would commit to “a rules-based international trading system and continue to fight protectionism”.
  • July: 25% levies were imposed on USD 34 billion of Chinese imports (with another USD 16 billion under review), following the 22 March executive memorandum instructing the US Trade Representative (USTR) to consider imposing higher tariffs on Chinese goods. The memorandum is the direct outcome of the Section 301 investigation of China’s practices related to technology transfer and intellectual property. The Chinese government had threatened immediate retaliation and cancellation of all previously agreed concessions. In turn, President Trump threatened tariffs on an additional USD 200 billion of Chinese imports.
  • The executive memorandum also instructed the Treasury Secretary to propose actions that would impose restrictions on Chinese firms seeking to invest in US companies that operate in industries or are developing technologies deemed strategically important. In late June, the White House confirmed that investments by foreign firms in sensitive US sectors, infrastructure and technologies would be subject to oversight by the Treasury’s Committee on Foreign Investments in the US (CFIUS), whose remit is itself being strengthened.

Trade dispute risks: under-appreciated

To date, our view is that financial markets have under-appreciated the risks associated with escalating trade disputes. Initial scepticism was based on the administration’s lack of concrete details, penchant for delay and flexibility in delay. Perhaps the administration was indeed anticipating that its trading partners would concede. But after rejections of the administration’s demands, and with retaliatory tariffs coming into effect, the argument that the administration was pursuing a strategy of only threatening tariffs looks too hopeful.

Furthermore, the economic and political costs of the strategy have so far been minimal. The response in equity markets has (so far) been muted, economic data has remained robust and the president’s popularity with his base appears to be strengthening, suggesting that the administration is unlikely to change course, at least not before the mid-term elections.

So, what are the US’s trade policy objectives?

The economic and geopolitical objectives appear to be to:

  1.  incentivise a reversal of ‘off-shoring,’ incentivising manufacturing to return to the US
  2.  re-establish and reinforce US leadership in high-tech, growth industries.

However, at its core, Mr. Trump seems to regard international trade as a zero-sum game in which deficits indicate a country is “losing.” The second assertion is that US deficits are evidence of unfair, unbalanced trade practices by other countries.

Frankly, parts of the administration appear to have only a limited understanding of how modern international trade works, with the highly integrated global supply chains that make the imposition of new tariffs extremely disruptive. Nor is there much apparent understanding that US trade deficits represent excess consumption/insufficient domestic savings by the US. Nor is there any acknowledgement that the administration’s parallel policy of running higher federal budget deficits will therefore aggravate trade imbalances.

‘America First’ conflicts with ‘Chinese dream’

Nevertheless, the administration is correct in asserting that the US, as the deficit country, can impose tariffs on a larger array of goods than can China or the EU, which gives the US leverage. However, the EU appears more focused on preserving the rules-based, WTO-administered system than on bending to US demands. China, on the other hand, has shown no willingness to concede on its long-term development goals. In other words, the “America First” trade agenda directly clashes with the “Chinese Dream.”

We note that 70% of the initial 1 333 Chinese product categories that could be subject to US tariffs are related to industries in Beijing’s “Made in China 2025” strategy that aims at developing and upgrading China’s high-tech, high value-added industries into globally leading positions. This suggests that longer-term strategic considerations are leading the US to seek trade policy outcomes that would limit the competitive threat posed by China’s technology sector.

Negotiations at a critical point

Negotiations have reached a critical point and will either end successfully or in a US-initiated trade war. Both the EU and China have demonstrated little hesitation in reciprocating. Furthermore, Chinese and EU tariffs look specifically targeted to cause political damage in key Republican districts and seem intended to assist Democratic gains at the November mid-term elections.

China and the EU will be hoping that any US move towards a broader set of tariffs (or unilaterally withdrawing from NAFTA) will provoke Congress into taking action to amend trade laws to claw back powers from the executive branch.

The threat of such action (as well as any threat by Congress to block the administration’s legislative agenda) should limit the risks of significantly adverse trade policy outcomes. And the risk of Congressional action to limit the administration’s trade authority will only increase in 2019, given that recent special elections and polls suggest the potential for a significant “Democratic wave” in the mid-terms.

From an investment perspective, we are taking the view that the tensions over US trade policy will escalate further, which warrants buying back nominal Treasury duration. For mandates that allow the use of options, we have bought out-of-the-money call options on Treasury futures as insurance.

*This article first appeared in the Inflation Linked Bond Outlook – June 2018


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