US-China trade: New tariffs – watch the second derivative

Our view about US-China trade tensions remains largely unchanged. We expect limited direct impact on the US economy, but the indirect costs could be more significant.

The direct macro cost on the US economy of the raised tariffs to 25% from 10%, and the fresh counter-tariffs from China, should be limited in our view, at around 0.1% of US GDP.

The US economy tends to be much more sensitive to financial conditions than to the narrow question of the tariffs’ impact on end-purchasers in the US. Those financial conditions, which have deteriorated in recent days, hold the key to the US growth outlook.

There are mitigating forces that could help support US growth: (1) The Trump Administration is stepping up fiscal spending, directly to US farmers affected by the Chinese counter tariffs and indirectly via increased military spending; (2) mortgage rates are coming down in the wake of lower Treasury yields, which could help the crucial US housing sector; (3) banks continue to provide accommodative lending conditions.

Also, there is already evidence of trade-rerouting of US imports of consumer goods from other, non-tariffed countries, like Vietnam.

The impact on US inflation should also remain limited. The evidence from the initial 10% tariffs seems to show a very limited pass through of the tariff to the US consumer. We expect a 0.1% boost to our annual inflation average. However, we acknowledge the risk of non-linearity with the escalation to 25% tariff.

Should the trade dispute escalate and lead to much tighter financial conditions, the Federal Reserve could cut rates, despite a bump in inflation. But for now we believe the bar to cutting interest rates is high.

Our view remains that President Trump is acting in the philosophy of his ‘Art of the Deal’ negotiation framework with ‘tariffs on / tariffs off’ being part of the show; ultimately we believe a strong stock market is key for him before the November 2020 election, when he will be running for a second term.

We expect both authorities to calm the escalation in the very near term. After recent tumult, the next step is still, in our view, that there should be some symbolic handshaking between Chinese President Xi and Trump at the G20 in June. Recent comments from Trump predicting a “very successful” outcome chime with this view. We do not expect tariff coverage of all Chinese imports in the near term, despite Trump’s ongoing threat.

Our worry mostly lies in how the bilateral relationship will develop in the longer run given the complexities of what is at stake, and the deeper question of economic and strategic rivalry. It would be erroneous to believe Democrats in 2020 would be a game changer, quite the contrary.

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