Economy & Markets

What you need to know about the trade war rollercoaster

As markets lurch on fast-changing tariff news, it’s tough to keep perspective. Discussion of global trade often generates more heat than light.

A primer on the subject—informed by an economist’s data-driven perspective—can be useful. Here, we try to distinguish between reasonable and misplaced concerns about trade imbalances, and explore policymakers’ often difficult choices. In a nutshell: Globalization has made the United States richer, we believe, but it has also made the U.S. defense sector weaker and less domestically based.

Before we dig in, a few observations: As this is written, the Trump administration has announced a 90-day pause on some of the tariffs it had imposed on nearly 100 trading partners. It kept in place a minimum 10% tariff on all imports to the U.S. and ratcheted up “reciprocal” duties on Chinese imports to 125% (fentanyl-linked tariffs of 20% and Section 301 tariffs on certain goods also remained in place).

The administration has argued that a new approach to trade will ultimately create greater national wealth and help reindustrialize the U.S. economy. U.S. Treasury Secretary Scott Bessent has referred to an “America First trade policy.”

But investors are not convinced. Equity markets sold off—and volatility spiked—amid broad concerns about the depth and breadth of the tariffs (and the methodology behind them). Stocks soared on news of the tariff pause.

Investors worry about the potential for tariffs (and perhaps a full-blown trade war) to constrain growth and boost inflation—relative to what was, at the start of this year, a more benign macro outlook.

All else equal, we believe tariffs will push growth lower and prices higher. Importantly, our base case remains that the U.S. economy will not enter a recession in 2025 or 2026, but we have raised our recession odds from 20% to 33%. (We wrote about how we derive recession odds, including the models we utilize, in an article published in January.)

In the following sections we consider:

Why do countries trade?
Is the U.S. trade deficit an imbalance?
How did China’s policy lead to its historically unprecedented trade surplus?
Should U.S. policymakers care about China’s trade surplus?
What are the key investment implications of today’s economic and trade backdrop?

Why do countries trade?¹

Trade among countries or regions has shaped human civilization for thousands of years. Economists see two main forces driving trade:

Countries trade because countries are different (comparative advantage)
Countries trade because of the advantages of specialization (economies of scale)

Comparative advantage

Comparative advantage is usually driven by geographic or “endowment” related reasons. For example, Canada runs a goods trade surplus with the United States (about USD 60 billion in 2024) that is entirely explained by the heavy oil Canada extracts from the oil sands in Alberta.

The United States needs Canadian oil, which is much denser than the oil extracted within U.S. borders, for a variety of uses. In particular, it is refined into diesel fuel and jet fuel for aircraft. Excluding Canada’s oil exports to the United States, Canada actually runs a trade deficit with the United States of about USD 40 billion a year.

Canada's trade surplus with the U.S. is entirely due to oil

$ billions

Source: Haver Analytics. Data as of December 31, 2024.

Other examples of comparative advantage driven trade in the global economy include Brazil’s agricultural exports, Saudi Arabia’s oil exports, and Australia’s metal and mineral exports. But we note an important difference between a natural comparative advantage and one induced by government policies. We find myriad examples of countries creating comparative advantage through subsidies or industrial policy, practices the Trump administration regards as unfair.²

For example, U.S. steel producers have struggled to keep up with South Korean and other foreign steel producers. South Korea does not have cheap power, domestic iron ore or other natural advantages to produce steel. But producers in South Korea do enjoy government support, which ranges from tax incentives to trade protection measures (tariffs and quotas on imported steel products), to direct financial subsides (low interest loans, debt relief and other financial grants).

Specialization

The United States stands out as a country that has increased its specialization in services, leading to a sizeable services trade surplus (about USD 290 billion in 2024). This specialization, especially in advanced technology and financial services, has coincided with a de-industrialization of the U.S. economy over the past 20-plus years (roughly since China joined the World Trade Organization in 2001). The Trump administration aims to reverse this key element of globalization through a revival in U.S. manufacturing.

U.S. de-industrialization has coincided with growing income and wealth inequality, which has inflamed political populism. In this context, it is important to acknowledge that growing inequality in the United States has a geographic component, driven by increasing the returns concentrated in a handful of “superstar” cities where the advanced tech and financial services are produced.³

There is no denying that increasing inequality is a negative side effect of specialization. From a macroeconomic perspective, however, specialization in services made the United States in aggregate richer and more technologically advanced than its peer countries—an outcome predicted by the economics textbook.

So that’s a big picture view of globalization. We next consider the overall U.S. trade deficit in the context of capital flows, exchange rates and growth dynamics.

U.S. de-industrialization has accelerated since China entered the WTO

Index (100 = 2000)

Sources: Michael Cembalest, Bureau of Economic Analysis, Federal Reserve, J.P. Morgan Asset Management. Data as of December 31, 2024.

Rising income inequality in the U.S. has been linked to widening geographic inequality

LHS: Standard deviation; RHS: Gini coefficient (0 to 1)

Source: Haver Analytics. Data as of December 31, 2023. Note: geographic inequality is calculated by taking the standard deviation of per capita personal income across all U.S. counties. The Gini coefficient measures income inequality, ranging from 0 (perfect equality) to 1 (perfect inequality), indicating how evenly income is distributed within a population.

Is the U.S. trade deficit an imbalance?

Despite the U.S. trade surplus in services, the overall U.S. trade balance has been in deficit since the 1970s. (It totaled about USD 900 billion in 2024, just over 3% of U.S. GDP.) Simply put, the United States consumes more than it produces, leading to trade deficits that are financed with debt, much of it purchased by global investors. The dollar plays an important role here, as we explain below.

Is a persistent U.S. trade deficit a problem that ought to be rectified by policymakers? If so, are tariffs the right policy tool to use? These questions are at the heart of today’s trade policy debate.

The economics textbook would say that the trade deficit is not a problem, at least in the aggregate, and that trade balances should be determined by capital flows and exchange rates. The United States is a relatively fast-growing developed market pushing the frontiers of new technologies (e.g., artificial intelligence). As such, it pulls in capital from the rest of the world, as investors seek exposure to U.S. growth assets, which pushes up the value of the USD exchange rate and makes U.S. exports less competitive on world markets. The result: a trade deficit.

U.S. economic outperformance explains the trade deficit

In other words, the U.S. trade deficit (in aggregate) results from economic outperformance rather than trading partners collectively taking advantage of the United States. This economic outperformance is also reflected in the high valuations of U.S. financial assets (e.g., U.S. stocks) relative to other countries’ asset valuations. Another sign that U.S. economic outperformance is linked to the country’s trade deficit: Foreign ownership of U.S. stocks has been rising secularly since the 1990s.⁴

U.S. stock market outperformance is closely related to U.S. dollar appreciation

LHS: S&P 500/MSCI World, January 1990 = 1; RHS: USD TWI, January 1990 = 1

Source: Bloomberg Finance L.P. Data as of March 31, 2025.

The causality is an important point. Many observers argue that the U.S. trade deficit is caused by profligate consumer spending, with U.S. households consuming more than the country can produce. But this ignores the fact that strong demand for U.S. financial assets can play a major role. Large capital inflows push up the value of the U.S. dollar, which is a global reserve currency. Along with making exports less competitive, these flows create a pool of foreign capital that Americans tend to spend on imports.

As we wrote in a pervious article, the U.S. dollar’s role as a global reserve currency helps explain why U.S. living standards are not constrained by the country’s persistent balance of payments deficit.

The dollar’s status as the global reserve currency bolsters living standards for U.S. citizens

Average daily income (USD) vs. current account balance as % of GDP

Source: World Bank Poverty and Inequality Platform (2024), IMF, Haver Analytics. Data as of December 31, 2021. Note: this data is expressed in international-$ at 2017 prices. Depending on the country and year, it relates to income measured after taxes and benefits, or to consumption, per capita. The data is adjusted for inflation and for differences in the cost of living between countries.

Globally, currencies tend to move to bring about an equilibrium in trade. As exports rise, the currency typically strengthens, eventually making exports less competitive. As exports then decline, the currency weakens. Currencies thus move to bring trade into balance. However, this pattern does not always prevail, and the United States has proved an exception. When there is very strong demand, such as for U.S. dollar–based assets, then the currency might remain strong, with trade deficits persisting for a very long time.

To summarize, trade balances are determined by legitimate comparative advantages or capital flows seeking stronger returns. In addition, however, policy choices may often influence trade flows. As we have noted, U.S. trading partners may subsidize their domestic exporters or manipulate their currencies versus the dollar in order to keep their exports competitive in the U.S. market. When Trump administration officials point to “unfairness” in the global trading system, they often reference an artificially overvalued U.S. dollar, the result of trading partners (notably China) manipulating their currencies to keep the dollar strong.

How did China’s policy lead to its unprecedently large trade surplus?

Is China a special case in terms of its trade and currency policies? It’s a complicated question but the simple answer is—yes.

While much of global trade conforms (more or less) to the economics textbook, China follows a different path. The country runs history’s largest goods trade surplus, of just under USD 2 trillion for manufactured products, the equivalent of about 10% of China’s GDP. This manufacturing trade surplus now dwarfs Germany’s and Japan’s during their eras of post–World War 2 export supremacy.⁵

China continues to run a massive trade surplus

LHS: China manufacturing trade balance, $ trillions; RHS: as a % of GDP

Source: Haver Analytics. Data as of December 31, 2023.

The economics textbook would not have predicted China’s massive and sustained manufacturing trade surplus.

China’s economic model did (arguably) follow the textbook until about a decade ago, when growth began to slow and policymakers asserted more control over the economy and over capital flows.

Until 2014, China’s strong relative growth was causing the RMB exchange rate to appreciate. But then China’s policymakers intervened to keep the currency weak relative to the dollar. Through domestic industrial policies (land subsidies, credit subsidies, tax incentives, relaxed regulations), Beijing prioritized continued export-led growth that ultimately led to today’s historically large manufacturing trade surplus.

The chart below illustrates this shift by plotting China’s GDP relative to that of the United States compared to the two countries’ relative inflation-adjusted exchange rates.

Around 2013/2014, China's economic model shifted

LHS: China-U.S. real effective exchange rate; RHS: China-U.S. GDP PPP ratio

Source: Haver Analytics. Data as of December 31, 2023.

Examples of China’s industrial policies and export dominance appear across several sectors, most prominently in clean energy technology, including electric vehicles. In just the past decade, China’s trade balance in low-carbon technology shifted from a deficit to a large surplus (of about USD 150 billion). China surpassed by a wide margin what had been the two leading exporters of low-carbon technology: Germany and Japan. Meanwhile, the U.S. trade deficit in low-carbon technology (about USD 80 billion) continues to increase.

In a decade, China’s trade balance in low-carbon technology moved from a deficit to a large surplus

Trade balance in low-carbon technology, $ billions

Source: CER analysis of IMF data on "Trade in Low Carbon Technology Products." Data as of December 31, 2023.

This line chart shows the trade balance in low-carbon technology for Japan, China, Germany and the United States from 1994 to 2023, measured in billions of dollars. In 1994, Japan’s trade balance in low-carbon technology was approximately $17.27 billion, China’s trade balance was approximately -$8.00 billion, Germany’s trade balance was approximately $8.46 billion, and the U.S. trade balance was approximately $7.84 billion. By 1998, Japan’s trade balance was approximately $17.68 billion, China’s trade balance was approximately -$6.91 billion, Germany’s trade balance was approximately $10.65 billion, and the U.S. trade balance was approximately $9.78 billion. In 2002, Japan’s trade balance was approximately $21.32 billion, China’s trade balance was approximately -$15.34 billion, Germany’s trade balance was approximately $12.87 billion, and the U.S. trade balance was approximately $4.32 billion. By 2006, Japan’s trade balance was approximately $33.46 billion, China’s trade balance was approximately -$43.03 billion, Germany’s trade balance was approximately $28.67 billion, and the U.S. trade balance was approximately $6.68 billion. In 2010, Japan’s trade balance was approximately $43.63 billion, China’s trade balance was approximately -$18.77 billion, Germany’s trade balance was approximately $32.76 billion, and the U.S. trade balance was approximately $5.49 billion. By 2014, Japan’s trade balance was approximately $30.50 billion, China’s trade balance was approximately -$4.85 billion, Germany’s trade balance was approximately $46.47 billion, and the U.S. trade balance was approximately -$1.78 billion. In 2018, Japan’s trade balance was approximately $47.05 billion, China’s trade balance was approximately $16.96 billion, Germany’s trade balance was approximately $54.61 billion, and the U.S. trade balance was approximately -$23.93 billion. By 2022, Japan’s trade balance was approximately $46.05 billion, China’s trade balance was approximately $108.02 billion, Germany’s trade balancewas approximately $64.93 billion, and the U.S. trade balance was approximately -$58.07 billion.

In other markets, such as excavators, China has been following a focused import substitution policy to drive out foreign brands. As excess capacity has built up, China is now exporting and dominating global sales.

Case in point: the global auto market. China’s rise as an auto exporter in just the last five years has been historic, facilitated by EV exports as well as cheap internal combustion engine exports to developing economies. In 2019, China was a net importer of passenger cars, but by 2023, China was the world’s largest net exporter of cars, exceeding Japan and Germany. By some accounts, China’s annual auto production capacity now approaches 50 million cars, roughly half of global demand.⁶

China is the world’s largest net exporter of cars

Auto exports by country; million units, 4-quarter moving total

Source: National sources, Haver Analytics. Data as of October 20, 2024.

In China, foreign brands have lost market share to domestic players

China excavator sales by brand origin as % of total

Source: Wind. Data as of May 2024.

Should U.S. policymakers care about China’s trade surplus?

At first glance, China’s trade surplus with the rest of the world could be seen as a gift. After all, from the perspective of the United States, U.S. paper IOUs (e.g., Treasuries) are exported to China in exchange for cheap subsidized goods that improve Americans’ living standards. What’s more, the global population could certainly benefit from China’s subsidization of clean energy manufactured goods insofar as it accelerates a global transition to low or no carbon emissions. This point is especially salient, given that climate change will likely cause the greatest harm to poorer countries.⁷

In short, Chinese export subsidies negatively impact its global manufacturing competitors, but they also weaken the Chinese economy, as they encourage inefficiency. Cheap goods, on the other hand, provide a positive global benefit.

What impact did the rise of China’s trade surplus have on U.S. manufacturing jobs? Of course, it’s a politically charged question. The United States was losing manufacturing jobs dating back to the 1970s, but the pace of job loss remained moderate even through 1990s. After China joined the World Trade Organization in 2001, globalization accelerated rapidly and U.S. manufacturing payrolls fell off a cliff. A total of 5.7 million factory jobs vanished between 2000 and 2010—nearly 10 times more than the losses of the previous 30 years, from 1970 to 2000.

U.S. manufacturing jobs plummeted as global goods trade rose

LHS: Manufacturing employees, thousands; RHS: World trade volume for goods relative to industrial production

Sources: Bureau of Labor Statistics, Haver Analytics. Data as of December 31, 2024. Note: the speed of the change in global goods trade relative to global industrial production is a measure of the pace of globalization.

An economist focused solely on the overall economy might say, so what? As we’ve discussed, the shift of U.S. production away from manufacturing toward services made the United States, in aggregate, richer. U.S. manufacturing jobs no longer pay more than jobs in the service sector—in fact, they pay less. ⁸But what is bad news for factory workers is also good news for U.S. consumers.

By one estimate, for every U.S. manufacturing job lost due to soaring trade with China in the 2000s, the U.S. consumer gained (via cheaper goods) about USD 100,000, or USD 200 billion in total.⁹

In hindsight, though, it seems clear the United States could have and should have done a better job managing the transition to a services-based economy. The human cost—and political fallout—was substantial. The U.S. government (and to some extent U.S. corporations) could have provided stronger support systems focused on redistribution and worker retraining to mitigate the growing inequalities associated with globalization. ¹⁰We see a clear link between rising inequality and political polarization and populism, which now threatens to turn back the clock on free trade and globalization.¹¹

And yet: Creating more U.S. manufacturing jobs is not in itself a very compelling goal if it means reversing the U.S. economy’s services specialization, and thus diminishing the country’s wealth.

The wealth versus national security trade-off

But what if the gains in U.S. wealth over recent decades came at the expense of national security? It may well be that the de-industrialization of the U.S. economy has weakened the country’s national security by making defense sector supply chains less domesticated and thereby less secure. From this perspective, one might argue that the United States has been following the economics textbook too strictly, failing to anticipate or address geopolitical impacts that might have been flagged in textbooks on, say, international relations or industrial planning.

In discussing U.S. reliance on foreign countries (especially China) from a defense sector point of view, analysts usually point to rare earth elements. These are critical ingredients in defense supply chains (used for fiber optics and imaging systems for missile and rocket components, etc.). China has achieved global dominance in processing them. On March 20, President Trump signed an executive order that aimed to immediately increase U.S. production of critical minerals; the order invoked the Defense Production Act to expand leasing and development on federal lands.¹²

China processes 90% of the world's rare earth elements

China % of global, %

Sources: IEA analysis based on S&P Global, USGS, Mineral Commodity Summaries, Benchmark Mineral Intelligence, Wood Mackenzie. Data as of 2022.

But the U.S. defense sector reliance on China involves much more than rare earth elements. In 2024, the defense software analytics company Govini published a detailed report on U.S. defense sector supply links, serving as a national scorecard across 15 critical technology areas identified as essential to future warfighting. The chart below summarizes the Govini report, showing the top-three country suppliers across the 15 critical defense technology areas. In 11 of the 15 categories, China is a top-three supplier.¹³

In 11 of 15 critical defense technology areas, China is a top-three supplier

U.S. defense sector supply chain reliance by advanced subsector category; number of suppliers by country

Source: Govini. Ark.ai. Data as of 2024.

The roster spans the gamut of technologies and advanced manufactured products that are essential for achieving security in the 21st century.

Govini found that over 40% of the semiconductors that sustain Pentagon weapons systems (including cruise missiles) and associated infrastructure are now sourced from China. From 2005 to 2020, the number of Chinese suppliers in the U.S. defense-industrial supply chain has quadrupled. That’s a key reason the 2022 CHIPS and Science Act aimed to bring semiconductor supply chains back to the United States.

The reliance on Chinese companies has fueled the growing U.S.-China trade war. From a U.S. policymaker’s perspective, this legitimate concern trumps (pun intended) the economics textbook’s emphasis on unobstructed trade and freely flowing capital.

This concern also helps explain the continuity in China policy from Trump to Biden and now back to Trump. Both Republican and Democratic presidents have embraced industrial policy, including the use of tariffs.¹⁴(And the CHIPS act passed Congress with strong bipartisan support.) In policy circles, we often hear variations of this quip: “If you don’t have an industrial policy, then you’re following China’s industrial policy.”

Concerns about national security are also growing outside the United States. In Europe, amid a frayed transatlantic alliance, many countries (but most notably Germany) are moving to further boost their defense spending and ensure their own security. “My absolute priority will be to strengthen Europe as quickly as possible so that step by step, we can really achieve independence from the USA,” said Germany’s new Chancellor, Christian Democratic Union (CDU) party leader Friedrich Merz. He recently unveiled a plan to exempt defense spending from Germany’s so-called debt brake—approved by the German Parliament in mid-March—and also announced €500 billion of new infrastructure investment.

European defense stocks have been on the rise for the better part of a year, with the Stoxx Europe 600 Aerospace and Defense Index up over 30% since August.

Investment implications

As investors consider an evolving framework for global trade, we highlight three takeaways from recent market developments:

As equities have sold off on concerns about tariffs’ negative impact, bonds have once again proven their worth as portfolio diversifiers. Markets have been volatile. But bond prices have generally risen (and yields have fallen) as investors appreciate the benefit of negative stock-bond correlation that is coming back into play. Bonds can play a vital role in portfolios by providing a steady stream of income and serving as a potential buffer against weakening growth, as we emphasized in an article published last year.
As trade policy uncertainty will likely persist for some time, investors may increasingly focus on sectors and companies that seem relatively insulated from tariff fallout. In the United States, consider domestically focused sectors such as utilities, real estate and telecoms.
Finally, we think the growing national security and trade conflict between the United States and China will have long-lasting repercussions. It is certainly debatable whether tariffs are the right approach for U.S. policymakers to use to try to stimulate the onshoring on critical defense sector supply chains. Regardless, we anticipate that the Trump administration will prioritize strengthening U.S. national security via more robust defense sector supply chains. Despite concerns about government spending cuts, we expect the defense and cybersecurity sectors will remain well supported. Also, with European countries increasing their defense spending, there may be attractive investment opportunities internationally that fall into the theme of national security.

A full-blown trade war, we began, would constrain growth and boost inflation. Yet our base case over the next 12 months remains a U.S. economy that steers clear of recession and a global economy that can weather the tariff shock.

Investors can find opportunities allocating capital to sectors, companies and strategies that are less exposed to tariff impacts and more exposed to the theme of upgrading U.S. and/or European national security. In sum: While the economics textbook advocates for unobstructed trade and capital flows, national security considerations require a more nuanced approach.

We can help

If you have questions about the possible outcomes we’re expecting for markets and for the broader economy, and how these may affect your investment objectives, contact your J.P. Morgan team.

¹The outline of this primer was heavily influenced by Paul Krugman’s Substack lecture series on international trade. Paul Krugman, “Trade flows and trade balances: A guide for the confused,” Paul Krugman, Substack.com, February 8, 2025, https://paulkrugman.substack.com/p/trade-flows-and-trade-balances.

²“We’ve been ripped off for decades by nearly every country on earth,” President Trump declared in his March 4, 2025, address to Congress. Using more restrained language. U.S. Treasury Secretary Scott Bessent said “International economic relations that do not work for the American people must be reexamined.”

³https://www.commerce.gov/news/blog/2023/06/geographic-inequality-rise-us

⁴According to data from the Federal Reserve, back in the mid-1990s, the foreign share of total U.S. stock holdings was about 5.5%, which has risen to 18% as of 2024.

⁵Brad Setser, “Xi Is Making the World Pay for China’s Mistakes,” New York Times, February 18, 2025.

⁶Brad Setser, “How German industry can survive the second China shock.”

⁷https://www.worldbank.org/en/news/feature/2023/12/02/for-the-poorest-countries-climate-action-is-development-in-action

⁸According to the Bureau of Labor Statistics, average hourly pay in services is about 10% higher than in the manufacturing sector.

⁹Xavier Jaravel and Erick Sager, “What Are the Price Effects of Trade? Evidence from the U.S. and Implications for Quantitative Trade Models,” Bureau of Labor Statistics Working Paper 506, September 2018.

¹⁰The United States offers comparatively fewer support and worker retraining systems than to most other OECD countries. See: Lane Kenworthy, Social Democratic Capitalism, Oxford University Press, 2019.

¹¹Duca and Saving, “Income Inequality and Political Polarization: Time Series Evidence Over Nine Decades,” 2014.

¹²https://www.4029tv.com/article/trump-critical-mineral-production-order/64251953

¹³https://www.govini.com/insights/2024-national-security-scorecard

¹⁴We first wrote about renewed U.S. industrial policy, and the drivers of it, more than a year ago. Back then, we didn’t see the national security angle as clearly as we see it today. Joe Seydl, “The Opportunity in Renewed U.S. Industrial Policy,” J.P. Morgan Private Bank, January 1, 2023. https://privatebank.jpmorgan.com/nam/en/insights/markets-and-investing/the-opportunity-in-renewed-us-industrial-policy

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