(This post appeared on my work blog in early October. Just a few days later there was progress on the trade talks. Conclusion? Both Trump and the Chinese read my blog!)
I regret to inform you that we are involved in a trade war.
I regret it, because months ago I told my colleagues to calm down, proclaiming
there would be no trade war. I believed that both China and the U.S. realized
that a trade war would be too damaging to both countries and, therefore, they
would strike some sort of deal. I even replaced the term “trade war” with
“trade conflict” in our company reports, when the countries were just in the
threatening stages. I don’t even like the term. It’s not like it’s a real war,
but that’s the term we use. So, I admit it: I was wrong, so wrong.
What impact is this “war” having? When it began, the media
went into panic mode, warning that the economy would be severely affected, with
some even predicting a repeat of the Great Recession. That hasn’t happened yet
because most journalists do not understand economics. Economics is basically
the study of how people react to changes in order to maximize their benefit.
Most dire predictions about the economy assume that people, and companies, will
not change their behavior due to the tariffs. And this is absolutely false.
People and companies adapt and make choices based on the new supply and prices
of goods. Therefore, it is almost impossible to predict the impact of the
tariffs as they are happening.
The business response to tariffs can be complicated. Take
the real case of a component supplier to the commercial vehicle industry facing
a 25% tariff on goods produced at their China factory. If you assume all costs
get passed on, the product cost rises by 25%. They raise their price by 25%,
which means truck and trailer OEM’s raise their prices to the dealers, who
raise their price to the fleets, who charge more in freight rates, which results
in higher prices to consumers.
However, this supplier, in this case, shifted its
production to Vietnam, resulting in just a 15% increase in costs. But the
changes didn’t stop there. Aftermarket customers balked at buying products from
the new Vietnamese factory until the quality could be proven, leading the
company to increase production at its U.S. factory. The supplier was also limited
in how much it could raise prices due to market competition. So, the company is
making less profit on roughly the same amount of sales, and there is minimal
impact on down the supply chain. While less profit is not good, it is not
catastrophic to the economy.
Also, I recently read an article about the effects of the
tariffs on a company that produces a consumable sporting goods product in China.
The company had achieved a dominant market share by utilizing cheap Chinese
labor to slash costs. It could then price its product under the competition,
and yet still achieve a higher margin. Now, due to the tariffs, its cost is
more than the competition, and it can’t raise prices due to the competitive
nature of the market. The company officer was whining excessively about how the
tariffs were eating into his profits. Pardon me, but it was your decision to
produce in China, which provided enormous profits and allowed you to crush the
competition. And now you are complaining that your profits are no longer
enormous. I just can’t feel any pity here. But this company is absorbing all
the impacts of the tariffs, and I am not paying a penny more for this item at
the store.
But the tariffs are having an impact. The farmers and other
“targeted” industries are obviously suffering. It should be noted that these
sectors are hurting as a result of Chinese actions. Instead of negotiating a
deal, the Chinese choose retaliatory, targeted tariffs. However, I am not going
to debate the merits or hazards of this trade war here. But how are the tariffs
impacting the economy?
Two areas where the tariffs are causing problems are
construction and manufacturing. Total Construction Spending was up just 0.1% in
August, and June’s and July’s tepid numbers were revised downward. Year-to-date
spending is down 2.3% versus the same period in 2018. How do tariffs impact
construction spending? The tariffs increase economic uncertainty, and this
decreases business investment. Business investment is an important element to
overall economic growth, and obviously essential to the construction market.
Manufacturing is also displaying weaker numbers. The ISM
(Purchasing Managers) Index for manufacturing was 47.8 in September, the lowest
value since 2009. It has been below 50 (indicating manufacturing activity is contracting)
for two months in a row. However, the index had been declining before the heavy
tariffs kicked in, so what is the impact of the tariffs alone?
Let’s compare the last time the ISM index cycled down in
August 2015, with this cycle in which began in August 18 (see graph). The ISM
in this cycle was stronger until we hit May 2019. And in August the downward
slope of the line increased. Therefore, a rough estimate of the impact of the
tariffs on manufacturing is the yellow area on the graph. It indicates the
tariffs began having a noticeable effect in May and it intensified in August.
The economic data from China is even more dire, with a
report indicating China’s economy is growing at its slowest pace in 27 years. I
may have been wrong about if a trade war would start, but I was correct about
the impact to both countries.
Therefore, this conflict needs to end soon. The uncertainty
is beginning to choke the economy, which would still be doing surprisingly well
without this anchor. We may be on our way to a manufacturing recession (in my
book, it takes six months at an ISM of 50 or below, and we are currently at
two). If China’s GDP can recover, it helps the world economy, which leads to
more U.S. exports.
There is still a lot of money sitting on the sidelines,
waiting out the war. As soon as economic peace is established, this cash will
come pouring back into the economy, providing a temporary boost. Which is
exactly what we need right now.
