To Weigh the US – China Trade Tiff, Avoid Extrapolation

When this correction began at January’s end, fears centered around wage growth, higher inflation and rising long-term interest rates. Though the upticks were small, many believed they were only the beginning of big surges, bringing trouble for stocks.^[i] US – China tariffs have now taken center stage, but the pattern is the same: Plenty fear they are the “first shots” in what will become a full-blown trade war—a Smoot-Hawley redux choking off global trade, tanking the economy and ushering in a bear market. In our view, however, there is little evidence suggesting these doomsday scenarios are likely. Extrapolating worrisome short-term trends into future catastrophes is tempting—and common—in corrections when emotions run high, but we believe it is a poor basis for weighing market risks.

At first blush, new tariffs seem to be coming thick and fast. US levies on imported steel and aluminum took effect March 23, with China one of just a couple major suppliers not to receive an exemption. China responded on Monday, April 2, implementing retaliatory tariffs on about $3 billion worth of US imports. Then on Tuesday the Trump administration unveiled a list of 1300 Chinese goods, worth about $50 billion annually, that may be subject to a 25% tariff. China responded on Wednesday, announcing its own list of $50 billion worth of imports from the US that could be subject to 25% tariffs. And just when it seemed like both sides were ready to call it even, President Trump asked his trade rep to ponder tariffs on another $100 billion worth of imports from China, which is already vaguely promising a “major response.” Right on cue, US stocks tumbled -1% in the first 90 minutes of Friday morning trading.^[ii]

If you see this and think, “Gulp, this looks like a trade war,” well, you would be right—in principle. Tit-for-tat is how these things start, and Thursday’s news does look like escalation. Yet “war” seems like too big a word for what we are dealing with at present. This is much more a “spat.” Media phrasing seems to be inflating investors’ estimate of the tariffs’ impact. Many articles refer to “$50 billion in tariffs,” implying each country would pay $50 billion in additional duties. Not so—the tariffs apply to about $50 billion worth of each country’s imports. This isn’t just semantics: Math says a 25% tariff on $50 billion worth of goods amounts to $12.5 billion. The president’s consideration of “$100 billion of additional tariffs” would seem to be similarly inaccurate—and overstated—shorthand. Rather, we’re likely talking about 25% of $100 billion, or $25 billion, added to the $12.5 announced earlier. $37.5 billion in tariff payments amounts to 0.2% of the $19.4 trillion US economy.^[iii] Or 0.05% of the $80 trillion global economy.^[iv] Add in China’s announcement to date and this would be marginally larger, but you are still talking about a fraction of a percentage point.

But even this much smaller figure likely overestimates the impact. First, the US and China aren’t the only countries producing the products announced earlier this week. If American and Chinese companies get these goods elsewhere—where the tariffs wouldn’t apply—total duties paid wouldn’t change nearly as much as simple calculations suggest. We doubt buyers will have much trouble finding new sellers, either: US tariffs are designed to target “substitutable” goods—those purchasable from other countries. On the flipside, although proposed Chinese tariffs target US soybean exports, soybeans are a basic commodity with deep global markets. South American production is the highest in the world, and Brazil has been stealing market share in China from the US for years. As for Chinese vehicle tariffs, these primarily hit European cars produced in the US. China could just buy those from Europe, while the US factories could sell back to the motherland. Don’t forget the power of the middleman, either: Companies outside the US and China could buy the affected goods and resell them to US and Chinese firms, further reducing tariffs’ impact.

While recent negative volatility seemingly suggests the planned tariffs threaten the bull market, we believe they aren’t nearly big enough. A bull-ending wallop would require lopping a couple percentage points off global GDP—in the trillions of dollars. This means much more sweeping tariffs that erase a few trillion in trade and duty payments. To get there, you would need many rounds of back-and-forth and a more global reach than just the US vs. China. Sure, all trade wars must begin somehow. But the vast majority of small spats go nowhere. To us, this seems the most probable outcome today.

Those fearing escalation should keep in mind the latest tariffs are only proposals. The US tariffs announced Tuesday are now subject to a public comment that lasts until May 22. From there, the administration can deliberate for another 180 days. Chinese officials say their tariffs will take effect only if the US goes ahead with its tariffs. All this delay leaves plenty of time for negotiations and compromises—something mutual demands for talks indicate both sides are keen on. Commerce Secretary Wilbur Ross says backchannel discussions are already happening. Brash talk followed by a pivot to dealmaking mode would follow the roadmap described in that timeless tome, The Art of the Deal: Start with big threats or promises, then walk them back as needed to reach an agreement. China doesn’t appear to be itching for a fight, either. Thus far, their responses to US moves have been proportional—they didn’t raise the stakes. Thursday’s retaliation seems mostly like posturing—and perhaps a bit of pandering to Trump’s base.

While we agree this saga merits close attention, headlines’ doom and gloom smack of guesswork and extrapolation—common correction tropes. Fearful investors seek reasons for stocks’ volatility, presuming negative recent trends will balloon into huge economic and market risks. The pattern goes beyond tariffs: After many extrapolated January and February’s small upticks in long-term rates into predictions of looming surges and a popping bond bubble, a Fed rate hike and briefly falling long rates sparked fears of a flat yield curve ahead. National debt worries also returned, with some using straight-line math to predict near-trillion-dollar annual interest payments a decade hence. This is a sharp contrast to how bear markets often start—with investors pooh-poohing real risks and fishing for reasons stocks will rise. In 2000, for example, analysts urged “buying the dips” as the tech bubble imploded, ignoring the inverted yield curve, a falling LEI (Leading Economic Index—the Conference Board’s collection of mostly forward-looking indicators) and dot-coms’ high cash-burn rates. None of this mattered in the new economy, the story went, where clicks were supposedly the new profits.

If—as we believe—we are in the midst of a correction, that means more bull market awaits on the other side, rewarding investors who fight the urge to act on frightening trade war forecasts. While anything is possible, we think the worst-case scenarios many picture today remain highly improbable. Now, in our view, is the time to watch and wait.