Markets & economy

Trade wars

In recent months, we have observed increasing uncertainty and concern among our clients about what impact rising international tensions, particularly the trade war between the US and China, will have on global and local economies as well as financial markets. In this, they are not alone. Sandy McGregor provides insight.

We have all been subjected to a plethora of confusing news and analyses of the potential impact of the ongoing trade wars. One way to gain perspective on this issue is to consider the evolution of international trade since the 1930s. 

Towards the end of the Second World War, America and Britain initiated discussions about how the post-war international financial and economic system should be structured to prevent a repetition of the calamities of the 1930s. The outcome of these discussions was the establishment of three institutions intended to facilitate a new financial order. At the Bretton Woods Conference in 1944, it was agreed to establish the World Bank to provide development finance, and the International Monetary Fund (IMF) to coordinate financial flows. Of equal importance was the General Agreement on Tariffs and Trade (GATT), signed in Geneva in October 1947, in response to the trade wars of the 1930s. GATT would later be succeeded and encompassed by the World Trade Organization (WTO).

From Trump’s viewpoint, America’s trade deficit is a vulnerability that gives other nations the power to tell America what to do

In the Great Depression of the 1930s, the value and volume of world trade collapsed. A significant contributor to this calamity was America’s Smoot-Hawley Tariff Act, which was passed by the Republican-dominated House of Representatives in May 1929 and became law in April 1930. The Act imposed draconian duties on American imports. At the time, it was strongly argued that there was no justification for such a measure. Economists and bankers implored President Herbert Hoover not to sign it. Business magnate Henry Ford called it “economic stupidity”. However, Hoover signed it all the same. He had already advocated increased tariffs in the 1928 presidential election. 

Since the founding of the American Republic in the late 18th century, isolationism had been a consistent American political agenda. In 1930, much of the support for tariffs came from constituencies similar to those who now support President Donald Trump. The consequences were disastrous: The world sank into a mire of tit-for-tat tariff retaliation, and international trade imploded. 

The interruption of normal trade relationships had devastating consequences and was a significant contributor to the global depression of the early 1930s. In 1933, an attempt was made to create a more rational trading system, but this was sabotaged by President Franklin Roosevelt, who preferred bilateral agreements, as are favoured by President Trump today. 

The resolution of these issues had to await a new generation of political leaders, after 1945, who were profoundly influenced by the disastrous consequences of the previous decade’s trade wars. Critically, there was now widespread support within the US for participation in the creation of a new international order under American leadership. The establishment of a process to harmonise and reduce tariffs became a priority. 

The first round of tariff negotiations in 1947 was followed by seven more rounds, ending in 1994. Over a period of 47 years, average tariffs were reduced from 22% to 5%. In 1994, GATT was succeeded by the WTO, which has since provided a rules-based international structure to handle trade disputes. 

The triumph of globalisation

The post-1945 international trade system evolved only gradually. Initially, the Cold War between the US and the Soviet Union caused a total separation of countries in the Soviet bloc from the market economies in the West. China, too, moved into isolation after the communist party seized power in 1949. 

The 1955 Bandung Conference in Indonesia promoted a distancing of third-world countries from Western economic models in favour of socialist agendas. However, as time progressed, the Western model based on market economies and international trade proved to be convincingly superior. Countries such as Japan, South Korea, Taiwan and Singapore used export-led growth to develop the modern, wealthy societies they are today. 

With the collapse of the communist bloc between 1989 and 1991, and China’s transition to a market economy in the 1990s, the world became one trading universe. China joined the WTO in 2001 and rapidly advanced to become the second largest trading nation after the US. 

By promoting market access, globalisation has enabled poorer countries to use export revenues to generate the capital they need to develop their domestic economies. Since 1990, globalisation has lifted more than two billion people out of poverty. It is remarkable how integrated the global economy has become: Business has become international. Sophisticated supply chains, structured to minimise production costs, span the world. 

Since economic growth is in part a matter of making things cheaper, consumers in all countries have been major beneficiaries of these developments. World trade has grown faster than the global economy as a whole and has been a significant engine of economic growth. 

Globalisation’s critics

The inexorable march to success has not been without its critics. Some nations have been unable to find any competitive advantage they can use to escape poverty. The political left tends to regard with grave suspicion a system which expands the power of big business at the expense of the authority of governments. Meetings of world leaders at the G7 and G20 Summits have often been besieged by angry antiglobalisation protesters, forcing these meetings to be held in secure fortresses. However, these opponents of globalisation have had little impact on business and international markets; it has been the advent of President Trump that has disrupted what was previously a very stable system.

Slowing investment would exacerbate the current global slowdown. The trade war could tip the world into recession

Trump’s world view goes back to the isolationism that was a dominating feature of American politics prior to the Second World War. He does not accept that America should be subject to an international consensus with which he does not agree. He has a mercantilist view of the economy, which is at odds with the paradigm of globalisation. In a global economy, it is of little importance whether a country runs a current account surplus or deficit. Trade balances are a manifestation of different nations’ saving habits. Germans, for instance, who save a lot, have a large current account surplus. Americans, who save little, have a persistent trade deficit. Financial markets promote the flow of savings to where they are needed. The national trade imbalances are of no more importance than whether California runs a surplus or Illinois a deficit. However, this comfortable proposition is not accepted by mercantilists, who view each nation in isolation.

Trump needs a trade war victory to bolster his 2020 re-election campaign

From Trump’s viewpoint, America’s trade deficit is a vulnerability that gives other nations the power to tell America what to do. He regards its trade imbalance as the outcome of a system that is increasingly stacked against American business. He believes that America must, at the very least, have a balanced current account. Above all, he wants to put America’s interests first, and is unwilling to compromise those interests to conform to an international consensus or promote global prosperity. 

Trade wars as a political necessity

It is noteworthy that, since the Republicans lost control of the House of Representatives in the 2018 midterm elections, Trump has aggressively used his authority to impose tariffs by decree to achieve his agendas. He can no longer get any controversial legislation through Congress. The threat of litigation limits his freedom to issue presidential decrees. Apart from foreign policy and his role as Commander in Chief of the military, imposing tariffs is one of the few unrestricted powers he has. Any legislation to curtail his authority in this regard can be blocked by a presidential veto. Trade wars are one of the few activities he can conduct without excessive interference from Congress. 

Public opinion about increasing tariffs on US imports is divided. A poll by The New York Times indicates that 49% of Americans are opposed to higher tariffs and 46% support them. Politically, the issue is divisive. Of those polled, 79% of Republicans supported increased tariffs, and 80% of Democrats opposed them. The consensus that allowed the US to play a leading role in rebuilding Europe and Japan after the Second World War has been shattered. Trade wars have the support of the constituency who elected Trump as president. The successful outcome of his various trade initiatives is of critical importance to his chance of being re-elected in 2020. 

America’s dispute with China

While the average American may be ambivalent about trade wars with countries such as Mexico and Canada, there is much broader consensus about China. China is regarded as unreasonably advantaged by three practices. Firstly, its theft of intellectual property is notorious. Secondly, Chinese businesses often receive state support, which makes it impossible for normal businesses operating within a market economy outside China to compete with them. Thirdly, while the world is largely open to Chinese business, much of China is closed to non-Chinese competitors. Americans are not alone in these concerns; they are shared by a large number of business leaders and government officials across the world. 

In 2018, China’s current account surplus was US$49bn, an insignificant imbalance for a US$13 trillion economy. Underlying this imbalance, however, was a trade surplus of US$420bn with the US and a deficit with other countries. China exported goods worth US$540bn to the US and imported US$120bn. The US had a current account deficit of US$488bn, of which the trade deficit with China accounted for 86%. It was this US$420bn imbalance that attracted the ire of the Trump administration, which is uninterested in China’s compensating deficit with the rest of the world.

Given complex global supply chains, when China has a problem, everyone has a problem

In true Trump style, negotiations about these and other American concerns were launched by a unilateral imposition of tariffs early in 2018. China responded in kind, and after a series of tit-for-tat escalations, the US imposed tariffs on US$250bn of imports from China by 18 September. China retaliated with tariffs on US$110bn of US exports to China. In December, Presidents Xi Jinping and Trump met on the sidelines of an international conference in Buenos Aires and agreed to a truce, suspending these tariffs while further negotiations took place. However, on 7 May 2019, Trump suddenly tweeted accusations that China was not negotiating in good faith and that he was imposing tariffs of between 10% and 25% on US$200bn of Chinese exports to the US. The Chinese retaliated and negotiations collapsed, with each side accusing the other of negotiating in bad faith. 

Both parties have strong reasons to make a serious effort to bring these negotiations to a successful conclusion. Trump needs a trade war victory to bolster his 2020 re-election campaign. China is finding it can no longer sustain its economic growth as it has in the past. A severe contraction of its exports would aggravate an already severe economic slowdown. 

Recent experience has shown that while monetary stimulus may not have much impact on the real economy, it does wonders for asset prices. However, this optimism may be misplaced if the world heads into recession

However, Trump has pushed the Chinese into a situation from which it may be difficult for them to back down. In 1842, the British defeated China in the First Opium War and forced China to open its markets to foreign trade. What followed was what the Chinese call a Century of Humiliation, during which Europe and America were effectively in control of the Chinese economy. President Jinping has publicly vowed that this will never happen again. Chinese officials say that America is demanding China change its laws to meet their requirements and submit itself to American judgement about whether it is fulfilling any trade agreement. Given its history, this would be very difficult for China to accept. 

Since the breakdown in negotiations in May, the Chinese government has mobilised public indignation against America and warned that China may face a struggle similar to the Long March, a year-long military retreat during the Chinese Civil War, which brought the communists to power in 1949. The genie of public indignation has been let out of the bottle and it will be very difficult to put it back. It will be difficult for the Chinese to go back to the negotiation table if Trump does not reverse his unilateral imposition of tariffs and conduct discussions in a way that does not offend Chinese pride. 

Now that both parties have looked into the abyss, negotiations may resume. However, even if they do, there is no guarantee of a favourable outcome. 

Global growth slows

A feature of an integrated global economy is that all countries experience a synchronous ebb and flow of economic activity. In the summer of 2016, growth accelerated almost everywhere. This expansion continued until the last quarter of 2018, when there was a widespread slowdown. This was, at least in part, a consequence of the increasing challenges facing China. These arose from their need to transition from credit-driven investment growth to a consumption-based society supported by growing disposable incomes. For them, the trade war has come at a very bad time. Given complex global supply chains, when China has a problem, everyone has a problem. There has already been substantial collateral damage to the European car industry, for example. 

If there is no immediate settlement and the draconian tariffs proposed by Trump and their retaliatory counterparts are implemented, business faces the problem of deciding whether these tariffs will be permanent. If Trump is not re-elected, a new administration might have a very different approach to these issues. This uncertainty could delay the restructuring of supply chains. 

In any event, the US economy is operating at full capacity and full employment. It will not be easy to rapidly relocate production onshore. While suppliers may absorb some of the cost of tariffs, most will probably be passed on to the consumer. Also, some domestic producers will take advantage of tariffs to increase their margins. 

Despite denials by Trump, tariffs are a tax on the consumer. Any tax increase has an adverse effect on the aggregate level of spending. Given the size of the US economy, the direct  impact of the tariffs on China will be relatively small, say 0.3% of GDP. However, if the trade war is expanded to other countries, the cost could become more significant.

More concerning is the impact on investment decisions, which could be delayed pending greater certainty about what the final trade construct will be. Slowing investment would exacerbate the current global slowdown. The trade war could tip the world into recession.

Financial markets have become increasingly sanguine about these disputes. It is difficult for anyone who expects the protagonists to act rationally not to believe that there will be a settlement. Furthermore, it is widely expected that if there is no settlement, both the US Federal Reserve Board and the Chinese monetary authorities will respond to any consequent slowdown with aggressive monetary easing. Recent experience has shown that while monetary stimulus may not have much impact on the real economy, it does wonders for asset prices. However, this optimism may be misplaced if the world heads into recession. 

Rising recessionary risks

It is now more than 10 years since the recession of 2008/9. In the case of the US, this has been the longest period of continuous growth in its history. During a long expansion, an economy develops increasing vulnerabilities. Central banks have used easy money to keep growth going. The problem is that sustaining growth artificially promotes inefficient and unsustainable practices. Debt accumulates to levels that threaten financial stability. 

The longer an economic upturn continues, the greater the risk of a serious recession. Usually, it is an unexpected and unusual event that precipitates the downturn. In 1973, for example, it was the oil shock. In 2008, it was the implosion of the US housing market. 

The trade war, with its disruption of international supply chains, poses a similar threat. It is possible that central banks will succeed in keeping the show on the road with an orgy of money creation. However, many are concerned that with interest rates very low, central banks no longer have the firepower to prevent a recession.

Investors are increasingly uncertain about whether the buoyant market conditions of recent years will last. Something will bring the expansion to an end. If it is not trade wars, it will be something else. It is an environment which urges caution.

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