Following the U.S.’s decision to raise tariffs of $34 billion on Chinese goods – mostly intermediate – that came to effect a couple of weeks ago, the U.S. is now planning additional tariffs on $200 billion of Chinese imports. Alas, the primary concern of many economists is that this could escalate into a trade war. If so, there are likely to be some winners and losers in it. Overall, such a trade war is more likely to reduce the volume of trade eventually, raise prices on some goods and services and reduce overall global welfare – which is likely to translate to slower economic growth not only in China but also in the U.S.. While China doesn’t import as much as the U.S. does (as of May 2018, China imported only $53, billion of goods while exported to the U.S. $205 billion and $130 billion and $505 billion, respectively in 2017), it still has ways of retaliating to the U.S. measures. Some of these measures include the devaluation of the Yuan, which has already depreciated against the dollar by nearly 4% over the last month, causing disruptions for U.S. companies that operate with their JVs in China and raising higher tariffs on U.S. imports; all these measures could also backfire at China.
However, President Xi, who has unlimited time in office, will have more patience to play this trade war out. In the U.S., however, the situation is more complicated, and it is possible, albeit not likely that Congress could constraint the powers of the President to impose tariffs on the grounds of national security if this trade spat does escalate into a full-on trade war on all fronts including with U.S. partners such as the EU and Canada.
However, I would like to focus here on the reaction we have seen so far in the financial markets, so far in the U.S., the situation has been rather calm. True, some companies devalued since tariffs were that are likely to be directly adversely affected by the tariffs such as specific manufacturing and industrial corporations. However, most of the major indices in the U.S. didn’t fall in the last few months and were pretty anchored (except for the NASDAQ that is up by close to 12% year to date). So why is that? Shouldn’t this uncertainty over trade wars, shifts in investments, disruption of supply chains and reduction in trading volumes be priced into the markets?
Several possible explanations come to mind: Markets still hopeful this back and forth between China and the U.S. won’t escalate to a full blown trade war; the reaction back in 2016 for the Brexit move led to a crash of stocks in both sides of the Atlantic only to reverse course within a matter of days – so perhaps some market participants feel this is a similar thing and don’t want to “miss out” on a possible rally; it’s hard to price in such an uncertainty until it appears in the data – perhaps markets just still don’t know how this trade war will affect the economy in general and companies in particular and until the markets see a change in hard data (e.g., drop in investments, jobs, etc.) they will still keep a close eye on this news as it develops but won’t selloff; earnings season has started in the U.S. and considering analysts expect another strong quarter of 20% growth Y-O-Y in earning for S&P500 stocks, the markets are less incline to selloff as the fundamentals – at least when it comes to earnings growth – remain solid; nonetheless, earnings will provide some indication if companies are preparing for the trade war and how its managers think these trade talks affect their businesses.
Thus, if more companies were to revise down their guidance for the year and voice more concerns over a possible trade war, the markets might start to react more strongly to this possible emerging trade war and we could start seeing a pulling back of stocks.