Trade woes are back, back again. Just when a deal seemed all but certain, U.S.-China trade tensions erupted again and sent markets for a wild ride this week.

First things first: What happened?

Last Sunday, President Trump tweeted a threat to ratchet up the rate of existing tariffs on $200 billion of Chinese goods from 10% to 25% at the stroke of midnight last night. The President also mentioned that he was considering whether or not to impose a 25% tariff on all remaining goods imported from China that are currently tariff-free. The tweet came in response to China’s attempts to backpedal on certain aspects of the deal that were previously agreed upon. Without any progress on a deal this week, higher tariffs went into effect last night, and Beijing has vowed retaliation.

But what do more tariffs mean? And why are investors worried about it? Consider the chart below, which shows the history of tariff rates charged by the United States. Globalization has been enabled, at least in part, by a reduction in tariff rates over time. Trump’s latest threats have materialized, so we’ve seen a tick up in the total tariff rate from point 3 to point 4 (the orange circle below). Importantly, if tariffs are further imposed on the remaining untariffed Chinese imports, we could see the total tariff rate jump up to point 5, effectively undoing over 45 years of globalization.

A century of globalization: U.S. import tariffs, 1900–2018 Line chart showing U.S. tariff rate on total imports from 1910 to 2019. The line has significantly fallen since its high in 1910, showing how tariffs have decreased over time as a result of globalization.

Markets aren’t taking the news too well. The S&P 500 has lost -2.5% since Trump’s tweet on Sunday. The Materials and Technology sectors are getting hit the hardest (down -4.0% and -3.7%, respectively). Energy (-0.7%) and Healthcare (-1.4%) are leading the market, but still look headed to finish the week in the red. U.S. 10-year Treasury yields dropped amid a flight to safety, falling to 2.44% from 2.53% since the end of last week. Gold, often considered a safe haven asset, has rallied +0.5%.

Outside of the United States, Chinese stocks have felt the brunt of the decline, as China’s onshore CSI 300 Index sank -4.7% this week. Japan’s TOPIX likewise dropped -3.1%, and European equities (-3.7%) are feeling a similar degree of strain. Today looks to be another rocky one, with higher tariffs intact and negotiators scrambling to find consensus during another round of talks.

But why poke the trade bear now?

Over the past couple of days, we’ve been trying to figure out why either side of the negotiating table would test the other when a deal felt so tantalizingly close. After all, we think both the United States and China understand that a deal is in their best interests and want one to happen.

As we alluded to before, both sides are playing the blame game. Officials from Beijing reportedly didn’t want a deal that required changes to Chinese law on forced technology transfer and intellectual property protections, despite agreements already made on those fronts. The United States viewed this as a last-minute attempt to renege on key aspects of the deal, frustrating negotiators and prompting Trump’s tweets.

A trade deal doesn’t seem as close as markets would have hoped.

Importantly, both sides likely view their relative positions as stronger than the other on the back of better economic performance. The Chinese economy is showing signs of stabilization, and the U.S. economy demonstrated solid growth in the first quarter. These developments might have encouraged both sides to feel more confident in negotiations.

Another possible explanation? Standing firm in negotiations with China might be the most politically appealing choice for President Trump. Most American voters view China’s economic power as a threat to the U.S. economy in one way or another. In terms of trade specifically, Gallup reported that in mid-2018, 62% of surveyed Americans viewed China as having an unfair trade policy with the United States. What’s more, even some Democratic leaders are vocalizing support of Trump’s get-tough approach to U.S.-China trade relations. Senate Minority Leader Chuck Schumer tweeted at Trump not to “back down,” and Senators Bernie Sanders and Elizabeth Warren also have views similar to Trump’s when it comes to trade.

“Please tell me if you believe [China] has a fair or unfair trade policy with the United States.” Pie chart shows how polled individuals responded to the question, “Please tell me if you believe [China] has a fair or unfair trade policy with the United States.” Of the respondents, 62% answered “unfair”; 30% answered “fair”; 8% had no opinion.

Given that China tried to go back on meaningful commitments in the negotiations, it seems the President was presented with two potential options:

  1. Go forward with the deal, placating the Chinese, U.S. corporations, and risk assets by removing the weight of uncertainty. This is the option the market had been pricing in, and would have been viewed positively by investors. That said, it may have been considered politically weak and a policy failure, exposing the Trump Administration to criticism from domestic political opponents arguing for more aggressive China policy, while also signaling to China that he is desperate to get the deal done.
  2. Call China’s bluff and hold out for a deal with more favorable terms, while twisting China’s arm with harsher tariffs. You could argue that the consequences of this option could be absorbed by the strength of the U.S. economy without much issue, and would allow the White House to stay consistent with its stance on trade negotiations. The downside is what we’re starting to see now: pain in markets, and increased uncertainty from corporate America.

As we’re now aware, the White House went with option 2.

Where does that leave us?

As expected, tariffs have increased to 25% on the $200 billion tranche of Chinese goods. The threat of additional tariffs on all remaining Chinese goods has not yet come to fruition, and we believe that this uncertainty is likely to continue to hang over markets. More volatility could be on the horizon as investors reassess the risk that tariffs could stay in place long enough to have a real impact on growth and earnings.

Bottom line: A trade deal doesn’t seem as close as markets would have hoped. Investors must now ask whether the positives of other recent developments (like easier financial conditions, stabilizing economic data and recovering earnings expectations) will be enough to keep the recent market rally going while the United States and China work to reach a compromise.

All market and economic data as of May 2019 and sourced from Bloomberg and FactSet unless otherwise stated.

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