Thursday, September 27, 2018

WARNING Don't Be Fooled, The Trade War Has Hit DEFCON 2

By David Stockman.

Folks, it's not a "skirmish". On the scale of trade warfare we are now at DEFCON 2.

At this very moment, the US is taxing $250 billion of Chinese imports or nearly half the total flow; and China is taxing $110 billion of its imports from the US or 85% of the flow.

And it's soon going full monte. The Donald has repeatedly threatened to tariff the remaining $267 billion of Chinese imports if Beijing retaliates against his $200 billion, but, self-evidently, they already have.

So it's time to start believing that the Donald will do what he says----unhinged or not--- under the trade file. That's because he's discovered the imperial presidency can virtually raise tariffs at will by abusing the rubbery enabling acts passed decades ago by Congresses which never imagined the Red Ponzi nor the Orange Swan which arose there from.

Thus, by year-end, $655 billion of two-way trade between the two largest economies on the planet will be subject to an open-ended tariff war that is truly unprecedented. Nothing of that magnitude has been remotely dreamed of by the protectionist lobbies in the past, but in today's memory-free fantasyland at both ends of the Acela Corridor it's being taken as just another something to gum about and then ignore.

Actually, the China Trade War is even more off the charts of known history because it is uniquely bilateral, and because both combatants are delusional about their own bargaining strength and ability to withstand their mutually inflicted blows---those that are already in force and those yet to come.
As we previously demonstrated, the full monte Trump tariffs on China will impact about $1.7 trillion of US goods consumption or 40% of the $4.3 trillion total annual PCE for durable and nondurable goods. That's because China is the overwhelming marginal supplier to the domestic market for goods, and the China Price drives the world supply curve.

So as the prices of imports from China rise by 10% now and 25% when the full monte becomes effective on January 1, prices for the 67% share of China supplied goods which comes from other foreign suppliers or residual domestic producers will rise toward the tariffed price umbrella.
To be sure, prices won't go all the way to the notional +25% price umbrella because competitors will come in just under the landed price of China goods plus the tariff, thereby taking market share. Depending upon supply elasticities, and whether we are talking about the short run or longer time periods, price increases will be lower than the full tariff percentage.

Needless to say, the lower the price increase (and the lesser the burden on US consumers), the greater the implied supply elasticity and loss of market share and volume by China producers to other foreign and domestic US producers. Even then, China suppliers----especially state owned companies that are in the social policy and jobs-support business---will have the option to cut prices to offset some or all of the tariff, and thereby slice their already razor thin profit margin even further.

But in general, we expect that the Trump tariffs will lift the China end of the supply curve significantly higher, thereby whacking domestic US consumers and moving volume and profits away from current Chinese suppliers.

So who will be the winners from the massive price umbrella that the Donald is in the process of erecting?

Why, it will be low wage places like Mexico, Vietnam, Indonesia, India, Bangladesh etc. and also Taiwan and South Korea, too, all of whom will be enabled by the Donald to steal market share from China and get a windfall gain from higher prices on their current shipments.

No wonder the new quasi-socialist government of Mexico, for example, appears not to be at all troubled by the Donald's Trade war: They are getting $16 per hour auto worker wages from their sidebar NAFTA redo with the Trump trade team and, soon, a huge gain in market share from China, too.

For instance, at the four digit product code level, China's imports to the US last year totaled $124 billion for the top two categories----cell phones/cellular network gear and computers and related peripherals. Those Chinese supplied iPhones and computers accounted for 63% of America's total $198 billion of imports in these two leading categories during 2017.

But it isn't hard to guess who was the next largest supplier. Namely, Mexico at $31 billion, and then South Korea with $6.5 billion and Taiwan with $5.5 billion. In all, the next three suppliers after China accounted for $43 billion of imports, and therefore clearly have the production base to rapidly cut into China's share.

We develop this point further below, but the fundamental flaw in the Donald's tariff strategy is blindingly obvious and can't be emphasized enough. Namely, historic protectionism generally involved high tariffs against all or most foreign suppliers, not just those of one country. For better or worse, the aim was to give domestic producers a cost advantage against all foreign producers up to the percentage level of the tariff.

The theory, of course, was that this cost advantage would enable production and jobs to migrate back home en masse.

The rejoinder of free market economists, however, has always been to point out the adverse trade-offs. That is, the higher costs to domestic consumers and the weakening of competitive pressures in the domestic supplier markets far outweigh the benefits of shifting production from foreign to domestic factories.

But the Donald's Trade War is a wholly different kettle of fish. Whether he understands it or not, his China tariffs amount to a weird exercise in global philanthropy. They will tax US consumers---and especially the Red State constituencies which live hand-to- mouth at Walmart----in order to transfer jobs and incomes to, among others, Mexico and Vietnam!

Our impression was that the Donald got elected by demonizing Mexico---so the likely outcome of his tariffs are more than a little bit ironic. But at least the production which gets shifted to Vietnam has a bit of logic----America probably does owe them some war reparations.

Yet what is not going to happen from the China tariffs is a material reduction in the $800 billion US trade deficit, nor any material return of production and jobs to the US.

When it comes to in-place production capacity the US isn't even in the game and has no obvious way to get there.

On the fully loaded global cost curve, in fact, the US is stranded up near the top due to the Fed's decades of 2%+ inflation. This means essentially that the Donald will be monkey-hammering US consumers with higher prices, but the output gains and windfall profits will go to other foreign suppliers much lower down on the supply curve.

We'd call this the art of madness, not deal-making of the type described in the 1987 book that the Donald, alas, didn't even write, or, according to the actual author, even proof- read.

In part 3 we will develop this shoot-yourself-in-the-foot model further. But for the moment consider the top 25 four-digit product codes, which accounted for $286

billion of imports from China last year; and which comprised about 55% of total Chinese imports in the thousands of four-digit categories.

In addition to all the Apple products made by more than 1.0 million Foxcon workers at $4 per hour or less in factories mostly in the interior of China, other leading categories include tricycles and wheeled toys, furniture, monitors and television equipment, lamps and lighting fixtures, trunks and suitcases, printing machinery, videogame consoles, electrical transformers, footwear, numerous apparel categories etc.

The key point is that these $286 billion of Chinese imports accounted for 52% of total imports of $556 billion reported in these 25 categories. But when it comes to where the other $270 billion of these goods came from and where they are positioned on the global labor and cost curve, the answer is again dispositive.

To wit, the next $61 billion came from Mexico!

That is to say, from supply bases that are low on the wage and cost curve, and which will be ideally positioned to grab market share from the Red Ponzi as the Donald's tariffs begin to bite.
And there something else. The slickest way to beat the Donald's tariff hammer will be for Chinese suppliers to ship-----in lieu of fully assembled iPhones----an alternative package of quasi-finished kits to Mexico for final assembly, packaging and re-export to the US.

To prevent that kind of natural market circumvention, of course, the Donald's Trade Nanny operation will have to drastically expand its rules-of-origin regulatory dragnet to stop the rampant end runs that are sure to follow.

After all, consider the $556 billion of imports in these top 25 mostly labor intensive categories. Exactly $286 billion of those goods will be taxed at up to 25%, while another $270 billion of identical goods in the same categories from the rest of the world will be taxed at 0%.

Can you say arbitrage?

The Donald's idiotic tariff-war-on-one-country is fixing to cause more upheaval and dislocation in global trade channels than can scarcely be imagined. But for what?

In Part 3 we will address the devastating impact this will have on the Red Ponzi, but in the interim it is well to think about the home front. That is, the accelerating inflation that is bound to creep into already strongly rising prices, and the door that will be slammed shut at the Eccles Building for those who might be looking for some way to defer or dilute Chairman Powell's belated normalization campaign.

In a word, it's going to bring on a jarring "yield shock" in the bond pits, meltdown in the stock averages, panic in the C-suites and the resulting recession on main street. Yet that's no more on the radar on Wall Street or in Washington than was the financial and economic collapse that suddenly incepted in September 2008.

But here's the thing. After decades of coddling by the Fed, the fear of financial fear has been essentially extinguished on both ends of the Acela Corridor. What is left is just dumb-ass optimism, like that which greeted this morning's report that consumer sentiment as measured by the Conference Board index has nearly returned to its all time peak reading of 144 in May 2000.

You would think that even the mention of a "sentiment" index at May 2000 levels would have triggered some alarm bells, but not in this moment of fantasy. Instead, MarketWatch, which is a perfect megaphone of Wall Street's delusionary grasp on the world, could barely contain the superlatives:

The economy is still growing rapidly more than nine years after the end of the Great Recession. Even a widening trade rift with China, the imposition of tariffs and a Federal Reserve bent on raising U.S. interest rates have done little to slow the economy down.

In fact, the aberrant 4.2% GDP reading posted for Q2 is readily transparent, and will soon mark the peak prior to the coming crisis.

But even if you are not willing to look at the massive headwinds looming in the windshield--- including the Donald's trade catastrophe---it is well to consider what
happened at this very same record high point of consumer sentiment back in the spring of 2000.

At least back then you didn't have a Red Ponzi tottering and an Orange Swam looming ominously over the landscape. In fact, there were still some pretty robust tailwinds visible in the rearview mirror; and which understandably had the capacity to delude the public into believing that stocks grow to the sky.

To wit, real GDP had grown at better than a 4.0% year/year rate for 16 quarters running, and had averaged 4.6% per annum over the four year period.

That's what the word "strong economy" actually means.

By contrast, here's the most recent 16 quarters. Not a single one is over 4% and during just two quarters did the year/year growth rate meaingfully breach the 3% marker.

Overall, the GDP growth rate over the last four years has averaged just 2.4%----even with the benefit of the Q2 2018 aberration driven by export pull forward and a one-time tax cut boost to consumption spending.

And that's not "strong" by any sensible definition of the term.

To the contrary, it suggests an economy that is badly impaired and which is limping towards its eventual rendevous with recession.

In that context, it rather hard to think of anything more foolish than today's endlessly repeated meme by the bubblevision talking heads that that now is the time to smash China in the economic solar plexus because the US economy is so "strong".

As we said, the Swan has a very Organgish hue and it now cometh with malice aforethought.

David Stockman was Director of the Office of Management and Budget under President Ronald Reagan. After leaving the White House, Stockman had a 20-year career on Wall Street.

The above originally appeared at David Stockman's Contra Corner.

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