- Fear of a developing “trade war” with China has run ahead of actual developments.
- Tariffs don’t necessarily lead to higher inflation, as the increase in prices is a one-time event that runs its course fairly soon after a tariff is announced. To the contrary, tariffs may dampen future demand, which could in turn weigh on inflation.
- China is unlikely to sell US Treasuries in response to the tariffs. China has more direct and targeted tools that we expect it to employ.
- With tariffs already in the headlines, the risks are now two-sided. US Treasuries would likely outperform if trade tensions were to escalate.
- We are positioned as before: optimists with regard to the ongoing recovery, but nevertheless committed to portfolio diversification through an overweight in US Treasuries.
Recent developments have raised the specter of a “trade war” with China and concerns about the attendant consequences. At this point, such concerns have perhaps run ahead of the actual developments. The tariffs on Chinese goods have not yet been implemented, and they are subject to a lengthy review period, during which the size and details can change. In fact, the scope of the aluminum and steel tariffs decreased substantially during the period between announcement and implementation. Further, the announced size of the tariffs is rather small, at least relative to the size of the US economy. Last year, the US imported $2.3 trillion of goods and services, accounting for 11% of the nearly $20 trillion US GDP. The announced tariffs will affect less than $70 billion of goods, or 3% of annual imports and only 0.3% of GDP. President Donald Trump’s threat of additional tariffs on up to $100 billion of goods would clearly represent an escalation, but it remains to be seen how the next phase of the negotiation plays out.
While the developments to date are arguably less ominous than commonly portrayed, it would be inappropriate to completely dismiss the concerns out of hand. The risk is that what starts small can end up growing into something much larger (which would make the points above accurate for the moment but less accurate over the long run). To avoid such a scenario, either China or the US will need to find a way to ease tensions and de-escalate the situation. It’s far from obvious how that will happen. Thus there is serious need to be attentive and analyze the potential consequences of the current situation.
The purpose of this note is not to forecast how the current spat might end. That is anybody’s guess. Rather, the intent is to take these trade tensions seriously and to discuss some potential impacts. As we have proceeded in these discussions at Western Asset, we have been struck by how misleading prevailing narratives about trade wars can be. Accordingly, the focus of this note is on two common misconceptions about trade wars. We attempt to dispel both.
First, our view is that a trade war would not lead to higher inflation. This is perhaps unintuitive, because many associate tariffs with higher prices, but the logic follows from a fairly straightforward economic argument, as detailed below. Second, in our view, selling US Treasuries is unlikely to be part of China’s retaliatory measures. Selling Treasuries is neither effective nor is it in China’s interest. Before dispelling these two misconceptions, it is useful to make a broader point about inflation.
The Environment Matters
Inflation in the US has been consistently below the Federal Reserve’s 2% objective over the last few years. At a juncture when some are convinced that inflation will move higher, aided in part by tighter trade policy, it’s perhaps useful to review why inflation outcomes have been disappointing.
As our senior economist Mike Bazdarich explained in a recent white paper (Low Inflation Is No Mystery), low inflation is fundamentally a reflection of tepid nominal spending growth. As long as nominal spending growth remains subdued, businesses are unable to raise prices without depressing demand. In that context, any exogenous increase in prices, due to tariffs for instance, would to some extent be absorbed by business margins, as increases in consumer prices couldn’t be sustained. Price increases not absorbed by margins may get passed on, but will subsequently lower demand. We’ll return to this point momentarily. To get any inflation, there would have to be a much different backdrop in terms of nominal spending growth, which is simply not in evidence right now. (Note: It is possible that tariffs could change relative prices, which could in turn lead consumers to substitute toward or away from certain goods. However, that is distinct from changing overall prices, and takes us beyond the scope of this note, which is focused on broader inflation.)
The point is that the environment matters. Absent a material change in nominal spending growth, isolated changes in prices, such as those that would result from tariffs, are unlikely to have much of an impact. With that broader context in mind we now turn to two common misconceptions about trade wars.
Misconception #1: Trade Wars Are Inflationary
A common misconception is that tariffs will lead to inflation. The reason for this belief is that such a link seems obvious—tariffs will raise prices and higher prices mean higher inflation, right? Not quite. There is an important nuance regarding the timing of the price increases and what we typically mean by “inflation.” It’s true that tariffs are likely to raise prices, even if it is not a one-to-one direct relationship, as some of the cost of the tariff is borne by the importer’s margins. What’s important, though, is that the increase in prices is a one-time event that runs its course fairly soon after the tariff is announced. Absent subsequent rounds of tariffs, there is no obvious reason why prices should rise again after the one-time event.
In contrast, when investors discuss “inflation” they are typically referring to an ongoing process that is expected to continue month after month and year after year into the foreseeable future. Indeed, the “inflation” most important to bond investors is the expected future rate of inflation over the life of the bond. A one-time increase in the price level due to tariffs has limited implications, if any, for the expected future rate of inflation over the subsequent years.
This is not to assert that tariffs don’t matter. One aspect of tariffs that may matter is the impact on demand. A one-time increase in prices will decrease expected future demand, which in turn could actually lead to lower consumer inflation. If tariffs raise the prices of, say, washing machines, then over the subsequent year one would expect not only lower consumption of washing machines, but also lower consumption of other goods, as consumers will have less disposable income due to the increased amount they do end up spending on washing machines.
Previous instances of tariffs being imposed provide suggestive evidence of the negative impact on demand. The imposition of the Smoot-Hawley tariffs in 1930 coincided with the onset of the Great Depression and the worst deflationary period of the last 100 years. It would be wrong to fully ascribe the economic collapse to the tariffs, but careful empirical work does confirm the expected link between higher tariffs and a decrease in US consumption.
This is a straightforward, if perhaps counter-intuitive economic argument that can be summarized as follows: A one-time increase in prices due to tariffs does not generate an increase in the expected future rate of inflation. On the contrary, a one-time price increase will weigh on demand, which over subsequent periods may even tend to depress prices.
Misconception #2: China Will Sell US Treasuries in Response
A second common misconception is that a trade war will inevitably lead to China selling US Treasuries. The arguments around this point are somewhat more speculative. That stated, while the possibility can’t be entirely ruled out, we think the chances of any meaningful Treasury sales are unlikely for two reasons.
First, China has more attractive tools at its disposal. China’s retaliation is likely to focus on actions that are targeted, politically salient and carefully calibrated. Its initial response has reflected all of these characteristics. China announced a specific list of goods that would be subjected to counter-tariffs, choosing goods that have some political importance (e.g., agricultural exports) and calibrating the amount to be exactly equal to the amount of US tariffs that these counter-tariffs are responding to. By focusing on these characteristics, China appears to be maximizing its bargaining position, while minimizing the domestic economic impact.
Notably, selling US Treasuries is an inferior option. Selling Treasuries is far from targeted. If any such sales were successful in pushing up yields (a far-from-certain outcome), the effects would be felt literally across the global financial system. The significance of such a movement would also be unclear. There are a large number of factors that push US Treasury yields in various directions. It’s entirely possible that Chinese sales could be followed by a period of lower yields, in which case some would rightfully ask, “What was the point?” Finally, for similar reasons, it would be almost impossible to calibrate the correct amount of sales needed to send a message without having an economic impact. As long as China has more attractive tools, it would seem logical to deploy those instead of selling US Treasuries.
Second, China holds US Treasuries because it is in its self-interest to do so. China accumulated US dollar assets during the 2000s to prevent its currency from appreciating too fast. Its current US Treasury holdings are simply an artifact of the previous desire to hold USD-denominated assets, and US Treasuries being a relatively low-risk way to do that. If China were to sell US Treasuries today, presumably it would be simultaneously selling US dollar assets. This would have clear currency implications, and China’s currency would likely appreciate as a result. An appreciating currency is not in China’s interest right now, especially if it came at the same time that tariffs made its exports less attractive. Moreover, any such blatant intervention in currency markets for political purposes risks undermining the work that China has done to establish its currency as a stable store of value and means of transaction. It seems reasonable to expect China to sell US dollars (and US Treasuries) when it is in its self-interest to do so, but not before then.
Assessing the Risks and Looking Ahead
As is always the case with markets, the risks are two-sided. Given the intense focus on trade tensions recently, it’s likely that market prices already reflect some of the downside risks. This is perhaps especially true in spread sectors—such as investment-grade credit and emerging market bonds—where the spreads relative to Treasuries have increased over the past month or so, as the trade tensions have risen. It could very well be the case that we have now seen the worst of the trade tensions, and that what has been announced thus far proves to be manageable for the US and the world economy. The news flow on trade could even improve from here, either due to a negotiated détente or even some kind of agreement in other trade areas. Any such positive development would presumably provide some support for spread sectors.
However, one can’t entirely discount the possibility that it gets worse. If trade tensions were to continue to escalate, it is not unreasonable to expect that to put further pressure on spread sectors. This risk case underscores the need for diversified portfolios. As our Chief Investment Officer Ken Leech recently argued, US Treasury securities remain the best diversifying hedge (1Q18 Market Commentary). Ken made this argument in a general sense, but almost surely the same applies to the risk case of a trade war. The reasons put forward for why US Treasuries may not be an effective hedge—tariffs are inflationary or that US Treasuries are in harm’s way due to China selling—are misconceptions that we have dispelled in this note. This leaves us positioned as before: optimists with regard to the ongoing recovery, but nevertheless committed to portfolio diversification through an overweight in US Treasuries.