I have never been a fan of tariffs as an economic weapon. In fact, I believe tariffs are a blunt economic tool and, in essence, a tax on consumers.
Before discussing the damaging effects of tariffs and the resulting trade wars that we are already witnessing in the U.S. economy, a bit of background is necessary. As the only remaining superpower after World War II, the U.S. adopted the principals of “competitive advantage” first extolled by David Ricardo and consciously led the world away from a zero-sum mercantile system toward a system of free (or at least freer) trade.
While there have certainly been losers under this system and players who have played unfairly — such as China — there is no doubt that free trade led to the highest global standard of living in the history of the world. In trade wars, however, there are no winners, and I believe a return to a mercantile system could slow economic growth in its tracks.
After 18 months of trade wars with China, Mexico and others, we are seeing some deceleration in economic growth and consumer sentiment. Some of this might be due to the fading impact of the Trump administration’s tax cuts, but more can be attributed to trade wars.
The U.S. stock market recently responded with significant volatility to the Trump administration’s call for an additional 10% tariff on $300 billion of Chinese exports beginning Sept. 1 (some of which have now been delayed until Dec. 15). Before proposing these additional tariffs, perhaps America’s farmers should have been asked if they are doing as well now as they were doing before these trade wars began. And what about their future? As countries develop relationships with suppliers outside of the U.S., who’s to say they’ll return? If, for example, China’s soy distributors purchase from farmers elsewhere to avoid paying U.S. tariffs, we cannot be sure that they will choose to buy their soy from their former supplier (the U.S. farmer) when the tariffs are lifted. For anyone who has ever taken Econ 101, this is what is referred to as the “substitution effect.”
Another outcome of tariffs and trade wars I foresee is that we will not continue to see the outsized stock market gains that we saw during the first half of the year. In the short term, the market might trade in a fairly narrow range. Investors worried that the U.S. will not come to a trade agreement with China are apt to cheer any such agreement, even if it isn’t a good one or if it takes us back to where we were 18 months ago. But investors should be careful not to stick their necks out and risk too much. The longer the trade wars go on, the greater the damage to the global economy.
On another economic front, the bond market is certainly taking the potential negative impacts of tariffs and trade wars seriously. The benchmark 10-year Treasury note yield was 1.72% as of early August, the lowest yield since November 2016. The yield on the 10-year Treasury note had been 2.6% as recently as two months ago. This significant drop surprised most analysts, including yours truly. And, while falling interest rates mean that bond prices will rise, they also indicate a lack of investor confidence in future economic growth.
Although it might not seem like it, I will stipulate that I am an optimist. I believe that over the long term, advances will continue that allow for robust global economic growth and corresponding investment gains. While many investors experienced great investment returns during the first half of this year, we should recognize that the current cycle has been unusually long and will not last. I do not think a recession or bear market is imminent, but I also do not think they are far off. When the tide inevitably changes, maybe these ill-conceived tariffs will finally be reconsidered and lifted.