If the market is not ready for China tariffs

If the market is up, thank the Federal Reserve.

Anyone betting on a further trade truce with China at the G20 Summit next week in Japan will likely be sadly mistaken … again. If the past is any indicator, tariffs on all of China’s exports to the U.S. are going up at some point this year. Nomura Securities made that prediction last week.

Meanwhile, trade uncertainty surrounding Mexico, the new Nafta (will it pass, will it not?), tariffs on some European automakers and, of course, the ongoing China trade war remapping supply chains all leave companies in limbo. Capital expenditures are at risk. Payrolls are at risk of further tariff escalation.

The market is not prepared for the business impacts of an ever-increasing trade war.

“Even though our base case assumes that further U.S. tariffs on China are avoided, our world growth forecast for 2020 has been lowered. Increased uncertainty about trade is already making firms more cautious on capex,” Fitch chief economist Brian Coulton said on Monday.

Weaker business investment in China, coupled with a decline in consumer spending growth in both the U.S. and China, have taken a toll on emerging markets and are leading to a rethink on world economic growth this year. The International Monetary Fund lowered its GDP estimate to around 2.6%, from previous estimates that had it closer to 3%.

Despite better-than-expected GDP performance in the U.S., the EU and China in the first quarter, the trade war is now a variable for the Fed. The market is up on rate-cut bets and not on hopes for a truce with China in Osaka.

Worth remembering: Trump and his Chinese counterpart, Xi Jinping, also agreed to a tariff pause at the last G20 meeting in Buenos Aires in October 2018. Around seven months later, the 10% tariff rate on $200 billion worth of Chinese goods more than doubled to 25%. Looking in the rearview mirror on this one is surely recommended.

If all was well with the global economy, the Fed would not be thinking of cutting interest rates and the European Central Bank would not be toying with the idea of returning to its asset purchasing program, propping up its local bond market.

Fitch says that the central bankers can cut rates down to zero if they want. The rejigging of global supply chains is a massive disruption, one in which money printing isn’t enough to entice businesses to invest. Such a remapping will be years in the making, if it doesn’t stop in its tracks in the event Trump is not reelected and a Democrat opts to either keep tariffs as they are now or cut them to pre-Trump rates.

“Central bank responses will not fully compensate for the impact of rising trade uncertainties on investment spending and the adverse supply-side impact of tariff hikes and trade restrictions,” said Coulton.

Incoming data suggests a forthcoming slowdown in business investment in the U.S. even as everyone is penciling in cheaper credit.

Manufacturing investment has slowed in China, regardless of stimulus there.

The euro zone is still weak, weighed down by the slump in global manufacturing, trade and Brexit.

Trade concerns impact commodity prices and that hurts commodity exporters like Brazil, which is struggling to jump-start its economy after a long recession and an ongoing political scandal. Brazil also has its lowest interest rates in at least five years.

Fitch is forecasting 2.8% global growth this year, down from 3.2% in 2018. The forecast is unchanged from their March 2019 Global Economic Outlook report.

Still, the trade war has yet to grind the economy to a halt. That should actually worry investors who think a trade truce in Osaka lasts the rest of Trump’s presidency. If Trump thinks the economy is growing and the market is doing fine, he will be more likely to pull the trigger on higher tariffs.

Fitch did manage to upgrade its 2019 forecast for the U.S., the euro zone, the U.K. and China due to strong first-quarter earnings. Brazil, Mexico, Russia, Korea, South Africa, Canada and Australia are all expected to underperform, growing less than originally forecast.

Last week, Apple made a surprise statement saying it could replace China as part of its iPhone assembly line. But overall, companies much farther down market who have grown reliant on China as a source for parts—like electronics components for car stereos—or as a buyer of commodities like soybeans are feeling the pain.

“Companies have three choices—all of which are erosive to the global competitiveness of U.S. manufacturers and ultimately job creation and retention,” says Nicole Lamb-Hale, a managing director at Kroll and fellow at the Duff & Phelps Institute. She says they can either “hunker down and weather reduced profits; find suppliers in third countries … or defray the increased cost of manufacturing inputs from China by passing costs on to their customers, making their products less competitive.”

Exporters to China are also hurt, led by retaliatory tariffs on agribusiness. Without agricultural market access to China for soybeans and pork, it will be difficult for farmers to replace that revenue.

“Subsidies from the government are not sustainable to make up the difference long-term,” says Lamb-Hale, a former Department of Commerce official in the Obama administration. “China will just find other sources for these crops and will not likely return when the trade war ends,” she says.

Last year, Brazil sold 10 million more tons of its soy to China than it did in the previous crop cycle due to the trade war—China has what amounts to sanctions against U.S. soy. China’s government importers are able to circumvent tariffs by not paying them themselves and transferring the soy shipments to the private sector, or can use Hong Kong or Vietnam as the buyer, and reship to mainland China ports. China has official ways around the tariff they set for themselves, but Beijing has forced the private sector to look elsewhere for soy. It is unclear if the U.S. is selling more soy to Brazil’s other main market, Europe. Brazil is increasing its soy acreage, also, to serve Chinese demand. This trend is likely to continue.

Fitch estimates that the trade war will continue eating into world growth, but not at catastrophic levels just yet.

They revised their growth target for next year down to 2.7% from 2.8% with cuts to both China (to 6.0% from 6.1%) and the U.S. (to 1.8% from 1.9%). Brazil’s booming soy exports won’t help them much. Fitch is forecasting its GDP to grow at 2.2% instead of a previous estimate of 2.7%.

The numbers get worse if Trump slaps tariffs on the rest of China’s exports to the U.S. The threat of 10% to 25% tariffs on another $300 billion worth of imports from China are very much on the table.

In the event that these tariffs were to be implemented at a rate of 25% on that $300 billion, and China retaliates, Fitch suggests world GDP falls another four percentage points next year.

China GDP would fall nearly 1 percentage point lower with blanket tariffs.

And the U.S. economy, while more resilient, would see another 0.5 percentage points trimmed from its growth rate, further hurting Trump’s chances of reelection. Markets would then begin to question what a Democratic White House would do with China. So far, none of the candidates have discussed China and have stuck to targeting Trump and domestic policies instead.

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