U.S. President Donald Trump and China’s Premier Xi Jinping continue negotiations for a trade deal which would prevent additional tariffs and potentially reverse some of the tariffs implemented last year. While Trump has delayed the additional tariffs on Chinese exports scheduled for the end of March, it is not clear when or if an agreement will be concluded.
- There is little evidence that a drop in U.S. exports to China has had a material impact on overall economic activity.
- In recent years the level of Chinese industrial production has not had much influence on the performance of U.S. or global equity markets.
- China appears to be at risk of a substantial slowdown if the trade tensions continue, but given the isolated nature of their economy the feedback to the rest of the world should be modest.
Market concerns about the potential disruption from further tariff hikes – and possibly other trade barriers – have periodically hit U.S. equity market performance. For example, the SPX plunged almost 6% in the two week’s following Trump’s initial threat of imposing tariffs on China in March of last year.
Figure 1: U.S. Total Exports and Exports to China as a % of GDP
The trade tensions have been a two-way affair to date with both countries imposing tariffs. While these barriers to trade have had substantial impact on specific U.S. export industries (e.g. soybean production), we believe the overall risk for the U.S. economy from loss of export is modest. As shown in the chart above, U.S. exports in total are about 8% of GDP but exports to China, while trending higher remain barely above half a percent of GDP. Moreover, while there appears to have been a modest decline in exports to China this past year, overall exports increased as a share of GDP. There is little evidence that a drop in U.S. exports to China has had a material impact on overall economic activity.
As is also evident from the prior chart, imports from China represent a much larger share of U.S. GDP than exports, so there is more significant risk that the imposition of tariffs could have a meaningful impact on overall U.S. price levels and hence inflation. The chart below suggests, while modest, there does appear to be some link between import prices and overall CPI inflation. Correlation does not imply causation and it is moot which is the primary driver of the coincidence of the connection in these price series. But for now, the issue remains moot as both import price increases and CPI inflation are trending lower. Some of the absence of feedthrough may reflect producer reluctance to pass on what they hope are temporary tariff costs to customers, so it is possible that failure to come to a trade deal – and, especially if tariffs are hiked further – could lead to positive feedthrough to import prices and general CPI inflation. As we saw late last year, if higher inflation forces the Fed back into tightening mode this could have a material negative impact on market performance and the economy.
Figure 2: U.S. Y/Y Import Price Change and CPI Inflation
But China’s Economy is Vulnerable
Whereas exports represent only about 8% of U.S. GDP, as shown below, historically exports have been over 20% of China’s GDP. Exports have been trending lower vs. China’s GDP at least since the financial crisis which to some degree may be a natural by-product of the government’s efforts to move China away from heavy reliance on exports as a driver of growth and development. Unlike the stable picture for U.S. trade shown above, Chinese exports to the United States have dropped sharply this past year as a share of GDP. Whether tariffs were the principal source of the decline, however, is not clear, as Chinese exports are dropping sharply vs. most of their major trading partners – Continental Europe is one of the few exceptions to this trend.
Figure 3: Chinese Total and U.S. Exports vs. GDP and Y/Y Real GDO Growth
The generally weak performance for Chinese exports would seem to make them more vulnerable to trade barriers with one of their most important trade partners – the United States. As shown above, China’s real GDP growth has trended lower since the recession and in 2019 hit its lowest level in over 20 years and declining exports are apt to weaken growth further. The government is limited in their options of alternative sources of stimulus since past efforts by the government to promote domestic sources of growth have created a substantial domestic debt overhang. An example of this is the rapid growth in domestic mortgage debt compared to GDP shown in the chart below. Continued government efforts to prop up property markets in recent years has allowed mortgage debt to continue growing even as the stock market went into decline. The government has made it clear that they are hesitant to promote yet more credit creation and resulting higher indebtedness to support domestic demand.
Figure 4: Growth in Chinese Mortgage Debt as % of GDP and the Shanghai Stock Index
What About a Feedback Effect?
There is little question that China is one of the biggest global economies which raises concerns that a Chinese down turn would ripple through the global markets. But while China is big, it is also autarchic. Its imports are primarily raw materials and capital controls keeps has deterred large foreign exposure to its domestic financial markets – 3M correlation between the Shanghai exchange and the SPX is only 14%. A decline in Chinese economic activity has a negative impact on commodity prices, but this is largely a zero-sum impact for global markets – bad for producers but good for commodity consumers. This was clearly demonstrated a few years ago when the surge of oil prices to well above $100 and then a plunge back below $50 had a marginal impact on global growth. More specifically, as shown in the chart below, in recent years the level of Chinese industrial production has not had much influence on the performance of U.S. or global equity markets.
Figure 5: Chinese Industrial Production and U.S. and Global Equity Performance
The Bottom Line
While Trump and Xi continue to work towards a resolution of the trade dispute and a lowering of tariff barriers, there remain significant risk that the conflict could deteriorate further. It appears the near-term impact on the U.S. economy of higher tariffs is modest though there is some risk that this could feed through to higher prices and ultimately inflation. Indeed, the biggest risk for U.S. markets is that high inflation would push the Fed back into tightening mode. China by contrast is already experiencing declining exports and growth with little room to create offsetting stimulus. China appears to be at risk of a substantial slowdown if the trade tensions continue, but given the isolated nature of their economy the feedback to the rest of the world should be modest.
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