Let’s talk about tariffs

“’Tis the times’ plague, when madmen lead the blind”¹

“The global economic system that has operated for the past 80 years is being reset”²

Many readers will have been bemused by President Trump and his team’s somewhat chaotic assault on America’s trading partner relationships, and their apparent willingness to shatter 80 years of political and cultural alliances in order to satisfy an extreme right-wing social and political ‘anti-woke’ agenda.  I won’t bore you with a simple narrative of the last few weeks’ events, but I do think there are four “big questions” that require some extended analysis.

Are Americans really being ‘Ripped-Off”?

“These countries around the world have had 70 years to do the right thing by the American people, and they have chosen not to.”

That statement by Trump’s Press Secretary, Karoline Leavitt implies that Americans have suffered through trade with other nations.  In fact, US per capita GDP (the average value of goods and services produced per person in a country each year) has rocketed since 1960 and is now 60% higher than the UK, double that of the EU, and more than five times that of China. Many countries implement selective import tariffs in order to protect their domestic businesses, and not just on the US.  However, analysis tells us that the US is far from the worst-treated by other countries.  According to UBS, the US need only add a 1.5% tariff on all imports to offset trade deficits, so what is Trump’s team thinking?

It is true that the US manufacturing base has shrunk dramatically over decades; since 1979, over 37% of manufacturing jobs have disappeared.  Manufacturing employed 26% of the US workforce in 1960 – that figure is now 8%. However, this is the impact of technology, globalisation and ironically the normalisation of relations with China in the 1970s. The US was successful on the surface nevertheless, but the cost has included increased inequality, and acute social crisis; alcohol and drug related deaths, along with suicides, have increased dramatically over decades and the pace is accelerating.  Those most severely affected looked for scapegoats, while those who got richer demanded lower taxes.

US infrastructure is often decrepit, particularly away from the coastal areas. Inequality is severe: the lowest 50% of earners own 2.5% of wealth, while the highest 10% owns two thirds of it. Life expectancy has fallen for three years in a row—a reversal not seen since 1918 or in any other wealthy nation in modern times.  Certainly, deindustrialization and rising inequality wouldn’t have happened without globalization; it is perhaps unsurprising that more than half the US population has been convinced that the rest of the world has taken advantage, and it’s time to get their money back.

US government bond yields are rising, and the dollar is getting weaker – so what?

US Treasury Bond yields reflect prevailing interest rates available for lending to the US government.  The safer the borrower, the lower the interest rate it needs to offer.  The less certain I am of your ability to pay me interest, the higher rate I demand before I’ll lend you money.  Bonds launched (say) 5 years ago have a fixed interest rate, that today may be less attractive, so I’ll pay you less capital for the same interest payment.  The yield on my investment is therefore higher.

If your interest rates are low, then fewer foreigners will buy your bonds.  Given they have to pay dollars for US bonds, that’s less demand for the currency, and its value falls.  Thus, there is a strong positive relationship between a currency’s value and its interest rate – yields go up, the dollar goes up, and vice versa.  However, that’s not what’s happening now.  A 5-year trend of rising bond yields remains intact but the dollar has lost almost 10% of its value versus other major currencies, and particularly the Euro, since Trump’s inauguration.  There is an implication here that the US’s reputation as a ‘safe-haven’ and role as the world’s key trading currency (90% of cross-border transactions are priced in dollars) is under threat.

Remarkably, this view is reinforced by the behaviour of German government bonds.  Despite its new government breaching decades of lending limits, and aiming to borrow almost €1 trillion (to boost defence spending among other things, thanks to Trump’s vice-president’s infamous Munich speech), Germany is seen as a safer bet than the US, evidenced by its bonds’ falling yields, and hence the widening premium expected of dollar lending over European investment.

Is China likely to capitulate to Trump’s 145% tariffs, or will he have to lose face and back down?    

The US administration may be migrating to a more authoritarian regime, but its democratic model remains founded on a separation of powers between the Executive (President and his cabinet), Congress, and the Judiciary.  Checks and balances abound (including a free press), not least of which are regulated capital markets; a free-market economy will always punish governments that act fast and loose with rich people’s money, as Liz Truss discovered.  China on the other hand has no qualms about controlling its population.  The Cultural Revolution saw millions killed through blind doctrinaire economics, while occasional uprisings demanding greater freedoms have been severely put down (e.g. the Tiananmen Square massacre). Their COVID lockdowns were the most draconian on the planet.  Meanwhile, the wider population strongly references a cultural myth pertaining to historical global mistreatment of Chinese; this was reinforced by US Vice-President JD Vance’s assertion that the US borrows money from Chinese “peasants” (by selling them US Bonds) so that they can “buy the things those peasants manufacture”.  All this from a man who celebrates his “hillbilly” upbringing.

The US is weaker than it looks.  The Chinese hold $800 billion of US debt (by owning bonds).  With Japan, the UK and Europe, that’s around $6 trillion of market weaponry if those countries chose to so use (by selling it).  The US stock market is 70% of global stock markets by value, but only 25% by GDP, and there are plenty of other countries to trade with. The US has more to lose, because it starts with more.

Are tariffs on, or off, or delayed? More importantly, do they work?

First, the rationale: Imports are lowering U.S. GDP by forcing us to produce less stuff, i.e. stealing American production. Trade deficits are therefore assumed to be a measure of how much is being stolen from America.  This view depends on two fallacies:

• “Imports reduce GDP”
  • Trump’s team notes that imports get subtracted from GDP. Alas, this is because imports also get added to consumption and investment, so you have to subtract them at the end to remove them from the number. Imports don’t affect GDP.
• “Imports will be replaced 1-for-1 by domestic production”
  • Assuming there are factories tooled to do it, selling at the same price and quality. American consumers could just go without a purchase, making everyone poorer.

The US is very good at producing certain products and services that have little competition elsewhere, e.g. via Microsoft, Meta, Netflix, AI services and so on.  However, if you are a country like Madagascar, a relatively poor country whose main export is vanilla, you are unlikely to be able to balance trade by buying expensive goods that are largely irrelevant to the local population.

A trade deficit is just like buying using a credit card.  The US just has less money and more stuff – it isn’t being ripped off.  Furthermore, not all purchases are for consumption.  Say a US company buys a Chinese machine tool for a million dollars. The toolmaker invests that in US bonds, adding to the trade deficit.  But if the US company uses the tool to make and sell $50 million of jet engine parts and exports those to the UK and Europe, that adds to the current account but it’s not reciprocal.  This is what Emerging Market companies have been doing for decades – running up trade deficits by importing machinery, industrializing rapidly and accelerating exports (which add to GDP!) to everyone else.

US imports from China aren’t just T-shirts and trainers. Almost 40% of those imports are used in the manufacturing and production process, rather than finished goods.  45% of all cars in the US are imported, indeed only 5% of a Lincoln Nautilus is made in USA.  85% is made in China.  The US’s biggest selling pick-up truck, the Ford F150, is 55% made outside US. Roughly 11 cents of every dollar U.S. consumers spend reflects the cost of imports at various stages of production.

As I write, the US now adds a 25% tax on steel, aluminium (including beer cans) and cars, with auto-parts due after May 3rd.  There is a 10% blanket tariff on every other country, with the respective reciprocal surcharges delayed until July. Chinese goods (with notable exceptions like laptops and smartphones, assembled for Apple) are taxed at a whopping 145% rate.  There is a 25% tariff on Mexico and Canada’s non-USMCA compliant goods.  In response, there are retaliatory tariffs against the US from China (125%), Canada, Mexico, and the EU (25% on farm produce and imports from Republican states).

So far, US companies have been using existing inventory, i.e. material imported before ‘Liberation Day’.  That will last around 3 months.  However, shipping container bookings and air freight from China to the US are already down 45% on April 2024. The Port of Los Angeles expects 33% lower dockings by mid-May.

President Trump seems to be getting the message from business leaders and his plummeting voter approval rates.  Alas he has responded by promising that tariff income (i.e. higher taxes paid by the American consumer, remember) would fund multi-trillion-dollar tax-cuts, and for some abolition of federal income tax altogether, to be implemented on Independence Day this year.  This nonsense raises further questions about his administration’s economic competency, or worse suggests an intention to fund crowd-pleasing tax cuts via increasing borrowing.  Neither will be helpful in supporting their currency.

In summary, we have chaotic policy-making, multiple U-turns on proposals, executive orders and the like, yet a clear withdrawal from alliances perceived to be liberal (EU, Canada) and a gravitation towards more authoritarian posturing (Russia, India, Italy, Hungary, Austria). Markets have no guardrails to operate within on as no government statements can be taken at face-value.  This is why markets have fallen, and then recovered somewhat as policy is reversed.  As more data is released over the next month showing the impact of tariffs on job hires, retailing and so on, the reality will become clearer, and policies reversed (one hopes) accordingly.

Graham Bentley
Chief Investment Officer

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¹King Lear, Act IV Scene I 

²Pierre Olivier Gourinchas, Chief Economist, International Monetary Fund (IMF)

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