The trade negotiations between the U.S. and China have been the center of the stock market’s attention for the past 6 months. One day it seems like they are close to a deal and then the next day both countries are launching new tariffs against each other.  While many investors in the U.S. understand the trade wars from the vantage point of the United States, very few people understand China’s side of the equation.   The more we learn about China’s motivation and viewpoint, the more we realize that this could be a very long, ugly, and drawn out battle. The main risk is if this battle is not resolved soon it could lead to a recession in the U.S. sooner than expected. 

1:  China Is Tired Of Being On The Losing End Of Trade Deals

When you look back through history, going as far back as the mid 1800’s, China has been on the losing end of many of it’s trade deals.  To summarize that history, when you are a very poor country, and your economy is based primarily on exporting goods to other countries, those countries that are buying your goods have a lot of power over you.  If you don’t agree to their terms, they stop buying from you, and your economy collapses.  China’s history is filled with trade deals where terms were dictated to them so they feel like they have been taken advantage of.

Now that China has the fastest growing middle class in the world, they are less reliant on trade to fuel their economy.   Also, the size of China’s economy is growing extremely fast. The size of a country’s economy is measured by their GDP (Gross Domestic Product). A country’s annual GDP is the dollar value of all the goods and services that are produced in that country in a single year.   It’s fascinating to see how quickly China has grown over the past 20 years compared to the U.S.

The numbers speak for themselves.  In 2000, the size of China’s economy was only 9% of the U.S. economy.  In only a 17-year period, China’s economy is now 67% the size of the U.S. economy and based on current GDP data from both countries, they are still growing at a pace that is about three times faster than the U.S. economy.

China seems to be making a statement to the world in these negotiations that terms will no longer be dictated to them.  China now has the economic firepower to negotiate terms as an equal which could drag out the trade negotiations longer than investors expect.

2: Tariff Impact On China vs U.S.

In May, the U.S. raised the tariffs on select goods imported from China from 10% to 25%.  China then retaliated by raising their tariffs on US imports from 10% to 25%.  We have heard in the news that these tariffs hurt China more than they hurt the U.S.    In the short term this would seem to be true. The U.S. imports about $500 Billion in goods from China compared to the $100 Billion in goods that China imports from the U.S.

But the next question is, “if it hurts China more, does it hurt them a lot or a little from the standpoint of their overall economy?”   The answer; not as much as you would think.  The chart below shows China’s total exports as a percentage of their GDP.

Back in 2007, exports contributed to over 35% of China’s total GDP.  As of 2018, exports represent less than 20% of China’s annual GDP.  Of their total exports about 18% go to the U.S.  So if you do the math, exports to the U.S. equal about 3.6% of China’s total annual GDP.   Personally, I was surprised how low that number was.   Based on what we have been hearing about the negotiations and how the U.S. is in such a strong position to negotiate, I would have expected the export number to be much larger, but it’s less than 4% of their total GDP.  This again may lead investors to conclude that the volatility we are seeing in the markets surrounding the trade negotiations may be an unwelcomed guest that is here to stay for longer than expected.

3: The Impact of Tariffs On The US Economy

While the U.S. is using tariffs as a negotiating tool,  it may be the U.S. consumer that ends up paying the price. That washing machine that was $500 in April may end up costing $625 in June.  Companies that are importing goods from China and selling them to the U.S. consumer will have to decide whether to absorb the cost of the tariffs which would decrease their net profits or pass those costs onto the consumer in the form of higher prices.

The other problem that you can see in this example is tariffs are inflationary.  Meaning they push prices higher. The Fed announced at their last meeting that they were content with keeping interest rates where they are for the remainder of 2019 given the slowing economic growth rate and tame inflation.  But if tariffs spark inflation, they may have to reverse course and raise rates unexpectedly to keep the inflation rate under control which would be bad news for the stock market.

4: Global uncertainty

Companies typically do not invest or make plans for growth if the global economy is filled with uncertainty, they pause and wait for the smoke to clear.   The longer the trade uncertainty between the U.S. and China persists, the more downward pressure there will be on global economic growth around the world. 

Summary

It’s unclear how this situation between the U.S. and China will play out and how long it will be before there is a resolution. In times of uncertainty, investors need to be very aware of how these trends could potentially impact their investment portfolio and it may be the appropriate time to begin building some defensive positions if you have not done so already. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.