Lazard Insights

Trade Tensions Begin to BiteRonald Temple, CFA, Co-Head of Multi-Asset and Head of US Equity

Summary• The effects of American trade policy have begun

to take hold, and the US-China trade dispute is becoming evident in US economic data and the redirection of US trade away from China.

• We see little possibility of the United States and China reaching a comprehensive resolution of their differences. Either a limited agreement or a suspension of trade war hostilities appear more probable. A further escalation of tensions seems to us the most likely scenario.

• The trade outlook has raised the probability of recession in the United States, although we still don’t consider recession the base case. A recession, if it did occur, could well prove mild, thanks to today’s record-low unemployment and robust consumer balance sheets.

Trade tensions have escalated substantially in the last year, both between the United States and China as well as between the United States and its major trade partners. While it has taken some time, the effects of US-China trade tensions are becoming clearer in both trade and economic data, as is the redirection of US trade patterns from China to other emerging economies. Furthermore, the policy tools brought to bear on the US-China trade dispute have evolved from a focus on trade deficits, negotiations, and tariffs to measures to address concerns over market access, industrial policies, intellectual property protection, and ultimately national security. Issues relating to national security could be particularly troublesome, as they are non-negotiable to a certain degree and hence may preclude a comprehensive resolution. To the extent a narrow deal is agreed on between the United States and China, we also would be highly skeptical of its scope and duration. In the United States, the narrative of China as a national security threat and strategic adversary has become embedded on both sides of the political aisle, which adds an element of uncertainty to the economic outlook. Uncertainty is the enemy of growth and leads to increased recession risk in 2020, although recession is not our base case scenario.

Lazard Insights is an ongoing series designed to share value-added insights from Lazard’s thought leaders around the world and is not specific to any Lazard product or service. This paper is published in conjunction with a presentation featuring the author. The original recording can be accessed via www.lazardassetmanagement.com/insights.

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A Multi-Faceted Trade Dispute It is useful to remember that the United States is engaged in a multi-faceted trade dispute. It has either threatened or actually implemented tariffs not just on China, but also many other trade partners.

In the case of its other trade partners, the United States has subsequently reached trade agreements with South Korea and with Mexico and Canada, although the latter has not been ratified by Congress yet. A US-Japan trade agreement is in the final stages of negotiation, while negotiations toward a US-Europe Union trade agreement is still in early stages.

In the case of China, however, the action so far has come both in the form of tariffs and in the form of more targeted measures, directed against specific entities, such as Huawei and ZTE, or specific issues. Importantly, given the national security implications of the US-China dispute, we should expect more restrictions related to technology equipment and services.

In total, US policies mark a substantial shift away from free trade. Currently, about 45% of US imports from all trade partners are either subject to or threatened by new tariffs (Exhibit 1).

The annualized run rate now exceeds $80 billion on approximately $400 billion of US imports. Assuming all the tariffs threatened to date are actually imposed, this figure would more than double to $180 billion per year on approximately $1,065 billion worth of imports, about $490 billion of which would come from China. The United States’ trading partners have responded with their own tariffs on US exports. So far, retaliatory duties have been smaller, with the global total at a run-rate of just over $20 billion of tariffs on a little more than $90 billion of US exports (Exhibit 2). If all threatened retaliatory tariffs are implemented, these figures would rise to $28 billion and $98 billion.1

The Shifting Composition of TariffsThe composition of Chinese exports subject to US import duties has shifted (Exhibit 3). List 1 and 2 tariffs of 25%, first imposed last summer and scheduled to rise to 30% on 15 October, mostly targeted intermediate and capital goods, used by businesses to produce goods and services. These tariffs took time to work their way through the supply chain and in some cases were not visible to end consumers as companies found ways to offset the cost pressure by negotiating lower prices from Chinese suppliers, taking advantage of a weaker Chinese currency.

Later rounds of tariffs began to impact finished consumer goods more directly. List 3 tariffs hit roughly $40 billion of consumer goods, but became much more meaningful when their 10% tariff rose to 25% in May (the 25% tariffs on Lists 1–3 is scheduled to increase to 30% on 15 October). Lists 4A and 4B, which extend

Exhibit 2~8% of US Exports Have Been Retaliated Against

Implied Tariff Value Based on 2017 US Imports

($B)

0

10

20

30Cumulative Value, ImposedCumulative Value, Threatened

Sep 19Jul 19May 19Mar 19Jan 19Nov 18Sep 18Jul 18May 18

As of 1 September 2019

Tariff value is calculated as 2017 value of trade muliplied by the tariff rate.

Source: USITC, WTO

Exhibit 1 ~45% of US Imports Are Threatened by Tariffs

Implied Tariff Value Based on 2017 US Imports

($B)

0

50

100

150

200

Sep2019

Jul2019

May2019

Mar2019

Sep2018

Jul2018

May2018

Mar2018

Jan 2018

Nov2018

Jan2019

Cumulative Value, ImposedCumulative Value, Threatened

As of 9 September 2019

Mexico and Canada were exempted from prospective tariffs on autos and auto parts in the US-Mexico-Canada Agreement on 30 September 2018, which has yet to be formally approved. Tariff value is calculated as 2017 value of trade multiplied by the tariff rate.

Source: USITC, WTO

Exhibit 3Further Escalation Will Affect Consumer Goods

US Imports from China Covered by Tariffs Based on 2017 Values

(%)

0

20

40

60

80

Con

sum

erel

ectr

onic

s

Furn

iture

App

arel

Toys

, spo

rtin

gan

d ot

her

Mac

hine

ry a

ndeq

uipm

ent

Ele

ctric

aleq

uipm

ent

Com

pute

rs

Com

mun

icat

ion

List 1 List 2 List 3List 4A, effective 1 Sep

List 4B, effective 15 Dec

As of 23 August 2019

Source: USITC, USTR

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tariff coverage to nearly all Chinese exports to the United States and go into effect on 1 September and 15 December respectively, hit nearly $100 billion of consumer goods.

Escalating tariffs on finished goods likely mean that the optics and substance of the trade war will begin to impact US consumers more directly starting in the fourth quarter as prices on retail shelves increase. List 4A tariffs hit apparel the hardest, with $25 billion of imports subject to the 15% tariff. Other categories affected on 1 September include $10 billion of computers, $10 billion of consumer electronics, and $9 billion worth of toys, sporting goods, and other similar items. The most critical items on list 4B, scheduled to take effect in on 15 December, are $47 billion of smartphones and $38 billion of computers.

The Shifting Patterns of TradeTrade, viewed more broadly, aligns with global industrial cycles (Exhibit 4).The deceleration in trade growth during the industrial slowdown in 2015 and 2016 is apparent along with its re-acceleration during the synchronized global recovery in 2017 and early 2018. The more recent deceleration also aligns with an industrial slowdown, as well as the trade war. Extending this chart back further, growth in global trade has declined substantially since the global financial crisis for a variety of reasons, including the exhaustion of the best opportunities to offshore supply chains following very rapid globalization from the 1980s through 2005. Much of this supply chain globalization coincided with the rise of multinational companies and trade through related entities, in which a domestic importer owns part or all of an overseas exporter. That structural globalization story has reversed somewhat since 2009, a phenomenon partly attributable to the changing trade policy and recent tensions.

As the trade war has escalated, we have seen a somewhat predictable reaction from American importers. They have slowly shifted their US supply chains away from China, to other foreign producers not subject to tariffs (Exhibit 5).

Imports from China are down about 5% year-on-year over the 12 months ended July 2019. At the same time, imports from Vietnam are up about 23% and from Taiwan over 15%.

Looking at how this has played out for two major product categories, telecom equipment imports from Vietnam have increased materially as imports from China have declined and, similarly, computers imports from Taiwan and a number of other countries have increased as those from China have declined (Exhibit 6).

Exhibit 4Global Trade Volumes Are Falling

Contribution to YOY % Change (%pts, 3-month rolling sum)

-3

0

3

6

201920162013

World

US Europe JapanOther Advanced

Emerging Asia ex-China China

As of June 2019

Volume of trade is calculated at constant 2010 prices. Trade includes intra-regional trade and excludes trade in services. Countries in the index are weighted by 2010 exports.

Source: Netherlands Bureau for Economic Policy Analysis, China Customs, Haver Analytics

Exhibit 5The US Is Substituting Away from China

US Imports from Major Trade Partners

YOY Change (12-month rolling sum, %)

-10

0

10

20

30

Vie

tnam

Taiw

an

Sou

th K

orea

Mex

ico

Phi

lippi

nes

Japa

n

Tota

l

Can

ada

Ger

man

y

Thai

land

Chi

na

As of July 2019

Calculation is the percent change in sum of the past 12 months over the sum of the 12 months prior to that.

Source: Census Bureau, Haver Analytics

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Upcoming MilestonesThis fall’s calendar contains a number of key dates on the trade front:

• A consultation on the Export Control Reform Act (ECRA) has been expected for several months. ECRA mandated that regulations on the export of sensitive technologies be updated with a focus on “emerging” and “foundational” technologies. Regulators are soliciting public comments on how best to identify and define these technologies. There is a justifiable concern that these categories will be defined in ways that are excessively broad, given the escalating economic and security tensions between the United States and China. If that occurs, it could significantly impair the ability of US technology and telecommunication companies to do business with certain foreign countries, most importantly China.

• The next round of trade negotiations between the United States and China are likely to take place in the second week of October.

• On 15 October, the United States is due to increase tariffs from 25% to 30% on imports from China covered under Lists 1, 2, and 3.

• 14 November is the deadline for the Trump Administration to determine whether it will impose tariffs on imports of autos and auto parts. Total imports are just under $300 billion, but we expect any tariffs to exclude imports from Mexico, Canada, and Japan, with the brunt falling on the European Union.

• On 15 December, list 4B tariffs are scheduled to take effect covering about $180 billion of products, including smartphones and computers.

Trade Deal ScenariosWe see four broad outcomes possible for US-China trade talks. However, even if the United States and China reach a deal regarding trade, the evolving view of China as a national adversary, rather than just an economic competitor, is critical to keep in mind. The tension between the United States and China is not going to go away, but instead will likely increase in our view.

We consider the chances of a comprehensive deal to be very low, at 5%, in light of the national security stresses in the United States. We see better prospects for a narrow deal that involves China purchasing more US commodities, agreeing to intellectual property protections, and improving market access while leaving the tougher issues around national security, technology competition, and industrial policies unresolved, at 25%.

An agreement to pause hostilities is another option, at 30%, but this should be seen as more of a stopgap, not true progress. It would leave US tariffs at current levels rather than raising or eliminating them and would force businesses to deal with ongoing uncertainty over the long-term state of the overall economic relationship and their supply chains.

Finally, we believe it most likely that the tension between the United States and China escalates, at 40%. This would involve failure to agree on a resolution in October and would lead to increased tariff rates and further retaliation from China.

Uncertain OutlookOverall, the outlook is best characterized by uncertainty against a negative backdrop—among other factors, negotiations to date have created bad blood, and recent US commentary has depicted Chinese President Xi Jinping as an enemy not to be trusted. Our negative perspective also stems from US security concerns. Unlike other countries, for which the United States delineates between the government and the private sector, Washington sees “zero daylight” between the Chinese government and Chinese companies, regarding many entities in China as foreign adversaries. This underlying skepticism regarding China’s motives

Exhibit 6Some Trade Is Getting Re-Routed

US Imports of Telecom Equipment

Contribution to YoY Change (% pts)

-20

-10

0

10

20

201920182017

Headline

China Vietnam Mexico Malaysia

South KoreaThailand Others

US Imports of Computers

Contribution to YoY Change (% pts)

-20

-10

0

10

20

30

201920182017

Headline

China Mexico Taiwan South Korea

EU Philippines Others

As of July 2019

Source: USITC, USTR

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and long-term intentions are shared across the Republican and Democratic parties. This is a rare case of bipartisanship and should be understood as an ongoing source of tension between the two countries.

On the back of these rising suspicions, the broader US-China relationship is suffering. Chinese foreign direct investment into the US declined by almost 90% from 2017 to 2018. The share of Americans who view China and the United States as “mostly partners” declined by 35 percentage points. And the number of US student visas issued to Chinese nationals declined by 10%, with anecdotal evidence indicating that tightening access to US universities has accelerated since 2018 (Exhibit 7).

Investment ImplicationsThe increasing uncertainty around the US-China trade relationship, not to mention the United States’ relationships with its other major trading partners, has increased the risk of recession in 2020. Recession is not yet our base case scenario, but we believe the risk is at its highest in over a decade.

However, context is important. Recession need not imply an event of the magnitude of the global financial crisis, but rather two consecutive quarters of negative GDP growth. In fact, there are significant buffers in place against a deep recession today, even if there were to be a near-term hit to corporate earnings—the unemployment rate is at a 50-year low, and consumer balance sheets are in a much more resilient position than before the crisis.

Furthermore, trade-related uncertainty, to the extent it is not resolved in negotiations by year-end, could sustain central bank accommodation well into 2020. Our broader concern is that additional central bank infusions of liquidity, such as the recently announced €20 billion per month of securities purchases by the European Central Bank, are likely to continue pushing up the

value of financial assets even as economic fundamentals weaken. That implies that if there were to be a recession, valuations could face substantial downside. That said, we must emphasize that recession is not our base case scenario.

Nevertheless, the risks and the economic backdrop make developed markets duration and credit unattractive. With over $15 trillion of government debt in negative yield territory and over $500 billion of corporate debt with negative yields, it makes more sense to invest in US dollar cash balances or emerging markets debt, where real yields are positive and where the currency risk associated with dollar strength has declined in tandem with the Fed’s easing trajectory.

Equities are not cheap, but they are less expensive than debt. We recommend an overweight but recommend de-risking by focusing on companies that can sustain high returns on capital through enduring competitive advantages and strong balance sheets while still trading at attractive valuations. Finding attractive valuations has become more challenging, and this is where security selection and deep, forward-looking fundamental research are critical.

The trade war also makes some sectors especially vulnerable. Some consumer discretionary companies may find it tough to pass through rising prices if tariffs increase. The technology industry is likely to be the target of non-tariff barriers. Unfortunately, there is little clarity on the form these restrictions might take—they could be narrow and affect specific companies, or they could be wide, affecting semiconductor manufacturers for example.

Beyond these two sectors, a range of companies and industries are likely to be affected as the two largest economies in the world engage in a trade war. To determine the appropriate implications for valuation in this environment, investors need to focus on the actual cash flow implications for the individual company and try to forecast the medium- to long-term impacts of the trade situation.

Exhibit 7The Broader US-China Relationship Has Been Damaged

Change, 2018 vs. 2017

(%)

-100

-75

-50

-25

0

US student visasissued to

Chinese nationals

Share of Americans believing China and the

US are “mostly partners”

Chinese FDI in the US

As of December 2018

Source: Ministry of Commerce of China, Bureau of Economic Analysis, The Chicago Council for Global Affairs, National Travel and Tourism Office, Haver Analytics

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RD00199

Notes1 Volumes of trade covered and value of tariffs are calculated based on 2017 US imports.

Important InformationPublished on 2 October 2019.

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