The great Trump reflation story, which points to strong equities, weak bonds and a highly valued dollar, is by now thoroughly entrenched in the minds of global investors. Not without reason. But when conviction is near-universal in markets it makes sense to ponder what investors might be missing. For my money the most likely flaw in this narrative relates to the cost of protectionist policies.
There is much that remains uncertain about the new president’s intentions. Yet one thing is blindingly clear. Donald Trump is prepared to risk precipitating a trade war whether by raising tariffs, introducing border taxes that penalise imports relative to exports, or both. The obvious precedent is the Smoot-Hawley legislation of the 1930s which may not have caused the Depression but unquestionably exacerbated it as the imposition of increased tariffs sparked retaliation and damaged world trade.
A trade war in today’s globalised markets may be a more complicated business because of the development of global supply chains. Increasing tariffs on Mexican imports would, for example, be extremely disruptive for American car manufacturers. Whether it would increase employment in the US is moot.
The Trump administration’s other target for trade penalties, China, looks an easier proposition. Supply chains are less convoluted. That is, the percentage of the value of US imports from China that originated in the US is insignificant. China’s exports to the US are much bigger than those of the US to China. Yet economic interdependence is too complex to permit easy wins.
For a start, calling China a currency manipulator as a prelude to protectionist policy, as the president has said he will do, would border on the surreal. Since 2014, the People’s Bank of China has been propping up the renminbi in the face of a surge of capital outflows as investors and businesses have sought to diversify and communist party officials have salted money away overseas for fear of being caught on corruption charges.
Beijing would inevitably respond to a trade assault from the US by ceasing to prop up the currency. The dollar would then appreciate even further than currently expected, thereby undermining the competitiveness of American exporters. The Chinese could also respond in kind to tariff increases.
At the same time American smartphone and computer giants have substantially outsourced manufacturing to China, so American customers, workers or shareholders would have to bear increased costs arising from higher tariffs or border taxes. Much the same would apply at Walmart and other retailers that are heavily dependent on imported Chinese merchandise
Then there is the problem of financial interdependence. Even after spending close to $1tn of its foreign exchange reserves in propping up the renminbi, China still has close to $3tn of official reserves, the greater part of which are invested in dollar denominated assets such as US Treasuries. Given that the Trump reflation will swell an already large government deficit, it is quixotic in the extreme to alienate the world’s second largest creditor country. The scope for financial instability if China decides to readjust the currency composition of its reserves is far from negligible.
Finally there is the question of which country is better equipped to absorb the pain of a trade war. Whatever the overall impact on the US economy, there will be extreme sectoral outcomes involving higher unemployment. A political price will have to be paid for that. The calculus for China’s rulers is very different. American trade skirmishing has the marked advantage of allowing them to whip up nationalist sentiment in response to the external threat. In effect, American protectionism is legitimising the undemocratic leadership and will create a climate in which it is easier for Beijing to abandon a growth target that can only be met with the help of excessive credit creation.
For good measure, the Trump administration’s withdrawal from the Trans-Pacific Partnership trade agreement gives China the opportunity to strengthen its position in the region. Nor is this the only windfall for Beijing. By casting doubt on the American security guarantee for Japan, South Korea and other Asian countries during the election campaign, the president has driven Asean countries closer to China.
Markets assume that the Trump reflation will take care of all problems. Yet a much stronger dollar than currently expected on the back of trade friction, if not war, could deflate the animal spirits on which the story depends.
