Notes from Washington: Trade War Redux?

We recently returned from Washington, D.C., where we hosted meetings with a mix of policymakers, former policymakers, and independent analysts, with a focus on the outlook and implications of the U.S. elections and broader Asia shifts. Much of the focus of this note is how policies could shift under a second Trump administration. We will follow up in future note with an assessment of the Harris policy implications. Note that some of the ideas in this note represent the perspectives of the speakers and/or interlocutors and are not necessarily the opinions of J.P. Morgan.

1. Tariff risks are real. Importantly, the goals appear to have changed. It could no longer be about a trade deal or even increasing U.S. exports, but simply blocking imports and pursuing limited decoupling. 
2. United States policy towards China could be more confrontational on trade, but it remains unclear how the broader policy stance will evolve. 
3. A 10% universal tariff on all imported goods has questionable legality, but would be quite disruptive if imposed. Some interlocutors suggested this could be a negotiating tool for countries to cooperate on other issues, and/or used to prevent trade re-routing from China.
4. Mexico, Vietnam were winners from trade war 1.0, and could likely stand to benefit from a further rise in U.S.-China trade tensions.
5. A key question is how the rest of the world responds. Will the rest of the world rally around the U.S. and push back on surging Chinese imports, or like trade war 1.0 will Chinese aggregate exports go up?
6. The potential market impact could be substantial. The tariff rates being proposed are a large increase from existing rates, while the risk of a blanket tariff and the potential for retaliation create a wide range for downside risk. 

Under a second Trump administration we could see a renewed focus on tariffs and a revival of trade war risks. However, a redux could look very different. The first difference is the magnitude. While the first trade war sent shockwaves through the global system, the total average tariff rate on U.S. imports from China only increased from low single digits to about 12%. An increase to 60% across the board would be a substantial increase and impact all goods rather than a few selected categories. Beyond China, Trump is also floating the prospect of a 10% blanket tariff. Such a universal tariff would have a significant impact on growth and inflation. 

The key question is whether the tariffs are a negotiating stance towards some eventual deal, or simply meant to block trade. There are good reasons to assume tariffs are a negotiating tool: in Trump’s first term tariffs were implemented across certain countries and products, but ultimately Trump’s team negotiated trade deals with China, Japan and South Korea, in addition to the USMCA with Canada and Mexico. There is a precedent for using tariffs as a tool towards a trade deal.

While it’s impossible to know exactly where Trump stands on this particular issue, one observation that stands from our recent conversations is that it sounds like there has been a shift in goals among many former policymakers and advisors with regards to trade, and particularly regarding China. In Trump 1.0 the goal was a trade deal. The Administration intended to pursue a multi-phase deal aimed at increasing exports to China, bolstering market access for U.S. firms, and getting China to undertake structural reforms. In their words, they struck a deal that requires “structural reforms and other changes to China’s economic and trade regime in the areas of intellectual property, technology transfer, agriculture, financial services, and currency and foreign exchange.” However the tone in Washington seems to have shifted. The experience of the last five years has resulted in the view that the global system has irreversibly shifted from one of ever- deepening globalization and towards a renewed focus on economic nationalism. As such, a trade deal that deepens the U.S.-China relationship and further integrates the two economies – making U.S. producers and companies even more reliant on Chinese demand – no longer seems to be the goal. The focus has moved towards decoupling. Based on our conversations, this appears to be designed to achieve multiple aims – first, simply sending less money to China. A clear message that came through in conversations is that the U.S. should not be funding its adversaries, and trade should be redirected towards friendlier allies, also known as “friendshoring”. The trade relationship between the U.S. and China is among the most imbalanced in the world and policymakers want to address it (see chart). The second aim is reducing U.S. reliance on China, particularly in critical minerals and other key goods. Tariffs would theoretically be used to drive an increase in U.S. production, or a shift of supply chains in strategic goods.

The final point is the concern of Chinese overcapacity. The common refrain from policymakers is that they will not allow the U.S. to suffer a “China Shock 2.0”. This refers to the surge of Chinese manufactured goods that entered the market after China joined the WTO, which led to a loss of jobs and industries. As China moves up the value chain, countries around the world are experiencing an increase of imports from China in sectors such as autos and advanced industrial goods (see chart). Echoing a recent speech from a senior U.S. Treasury official – as China’s property sector slows and domestic weakness emerges, there is a likelihood that China will rely on foreign demand to sustain its future growth. When China relies on foreign demand for growth, and especially when sectoral trade surpluses grow rapidly, the resultant loss of jobs and reduced wages can create lasting and significant damage to individuals and communities around the world, particularly those with low incomes. 

Why has the view towards tariffs and trade seemingly shifted?

The overarching view in Washington is that China is not going to shift policies, as the previous structural reforms they sought are now believed not achievable. Moreover, there is significant discomfort with the level of dependence in certain goods and sense is that the U.S. has to position itself for long-term competition with China. Reducing touchpoints and support for China’s economy seems to be the goal in and of itself.

While the goals have seemingly shifted among many of Trump’s key advisers, it goes without saying that the ultimate policy would lie with Trump, which in turn creates uncertainty over what any trade policy might look like. As we know from his first term, a deal was the overarching goal and Trump has often portrayed himself as a dealmaker. Thus, it’s impossible to draw firm conclusions around the use of tariffs. Another unanswerable question is that if a deal is the goal, what does that deal look like? 

Overall, changes in China policy under a Trump administration could be mixed. Trade could be more tense, but perhaps less confrontational in terms of tensions over the war in Ukraine, human rights, or overall coordination with allies on economic containment. In this way, from China’s perspective the result could be mixed. Much will hinge on whether a second Trump A administration continues Biden’s approach of working with allies, or if they choose a ‘go it alone’ approach. 

If we see an increase in tariffs, what are the potential impacts?

Firstly, what is the potential impact of tariffs on China? Following the first set of Trump tariffs in 2018, China’s share of U.S. imports fell from 22% in 2017 to 14% in 2023, with goods facing higher tariffs falling by more. Mexico, Vietnam, Taiwan, Canada and Korea all gained market share. While in one aspect this was simple trade re-routing – for example China’s exports to these economies also grew more than to the rest of the world – there is some evidence that the economies that gained U.S. market share from China saw meaningful economic gains. Going beyond trade re-routing, supply chain shifts are occurring and global foreign direct investment (FDI) into Vietnam and Mexico has picked up in recent years. 

U.S. tariffs in the range of 60% on Chinese exports would have a meaningful impact on China, according to simple models. It goes without saying that estimating the impact of a trade war is complicated, with variables such as retaliation, offsetting stimulus, currency moves etc., all playing a role. Nonetheless, in a simple scenario the average U.S. tariff rate on Chinese goods would increase by 48ppts to 60% from the current 12% (trade weighted). Such an increase would squeeze a substantial amount of Chinese exports out of the U.S. market. Using 2023 data China’s total exports to the U.S. amount to 14.8% of China’s total exports and 2.8% of China’s GDP. With China’s domestic value added at 82.1% of gross exports according to the OECD TiVA database, it could reduce GDP growth in the range of 2.0-2.5ppts over the following 12 months. The impact would be felt directly through the export channel and indirectly through a decline in consumption and investment. Policy support could offset some of the impact, making an accurate forecast very difficult. 

Is the potential resulting U.S. inflation and negative growth impact enough to prevent policymakers from going down this path? 

Here it’s important to distinguish how impactful tariffs on Chinese imports would be for the overall inflation picture. Core goods account for 20% of the core PCE basket, and 35% of core goods are imported. In the scenario where tariffs are hiked on imports from China, the headline tariff rate could increase by around 48%. As imports from China account for 13.5% of all imports, this would all mechanically translate to 45 bps upside for core PCE inflation (20% x 35% x 13.5% x 48ppt = 45bps). By the same calculation methodology, a 10% tariff on all core goods would result in an initial upside of 70bps for core inflation (20% x 35% x 10ppt = 70bps).

However, the final effect on inflation will depend on a number of other factors. These other factors, similar to those listed above, such as currency depreciation, trade diversion, or government stimulus, could play a bigger role in influencing core goods inflation rather than just the direct effects of tariffs. While it’s not a direct comparison, it’s worth noting that over the 2018-19 trade war, inflation remained in negative territory and in a range between -0.9%Y and -0.1%Y (see chart). The overarching view was that the inflation impact was not enough of a concern to prevent policymakers from going down the path of higher tariffs on China.

A key factor is how China and the global economy reacts. It goes without saying, but China’s response to any trade war is a crucial factor – as they could retaliate, negotiate, or do nothing. Retaliation that impacts U.S. corporates and feeds through to the stock market is still seen as a crucial constraint. We’re still three months out from the election and there are bound to be twists and turns, but as we evaluate the potential policy paths that could impact Asia, trade is one that bears close watching. 

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