The global economy has undergone a fundamental shift in recent years. The rules-based, free and open international trade regime that dominated the latter half of the 20th century and first decade and a half of the 21st century has cracked and broken, giving way to a new era of trade populism.
Of course, this fundamental shift is not complete. It is ongoing. And it is primarily a political shift, not one initiated by market forces. Hence we find that, despite a declining US trade deficit in the back half of 2019, that deficit has powerfully reasserted itself in the wake of the coronavirus pandemic.
In August, 2020, the US trade deficit reached a 14-year high, coming up just shy of the all time high reached in 2006. This even as the trade deficit with China, specifically, fell by 6.7%.
Interestingly, the COVID-19 recession of 2020 differs from previous recessions in that it dramatically increased the trade deficit, whereas previous recessions decreased the trade deficit. Total US trade is down 15.1% this year, which means that as the US pulls out of its shutdown-related economic slump, consumers and businesses are purchasing more imported goods from our trading partners than they are from us.
Unfortunately, as I will discuss below, this tectonic shift in trade policy is unlikely to change anytime soon, even if the residents of the White House change next year. That will be the topic of the first section below. After that, I will explain why this paragraph begins with “unfortunately.” Recent economic research put out by the Federal Reserve has shown that the trade war brought on by this policy shift has (1) done more harm than good to the American manufacturing sector and (2) depressed US investment growth.
I’ll close with some thoughts on how this politically popular but economically damaging tectonic shift will affect the US economy going forward, and how investors can position themselves.
The Tectonic Shift
A 2020 study titled “Going It Alone? Trade policy after Three Years of Populism” put out by the Brookings Institute says yes, free and open trade across borders is on the decline across the world. From January, 2017 through the end of 2019, the researchers found a total of 6,755 policy changes in the areas of international trade, cross-border investment, data flows, and labor migration. In those three years, the number of new policies designed to harm foreign commercial interests surged.
The percentage of total world trade affected by policies introduced since January, 2017 has jumped from 20% in 2017 to 40% in 2019. In other words, more and more cross-border trade is being affected by recently implemented trade policies, most of which are protectionist in nature.
But these trade policies do not just affect cross-border trade that is actually carried out. It also affects commercial transactions that might otherwise have been carried out. In many cases, governments offer financial incentives to domestic businesses to reduce cross-border trade. By the end of 2019, “over a quarter of world goods trade were being distorted by the tax breaks and dubious financial terms offered by governments to their exporters.”
As such, the weapons of a trade war are not just tariffs but also subsidies and tax incentives. The researchers write:
Targeted trade policies of the type deployed by Beijing and Washington are a sideshow in comparison to the scale of commerce affected by market-distorting export incentives. Media coverage notwithstanding, the bigger trade problem is the attempt to steal sales in markets abroad from foreign rivals, not denying selected trading partners access to one’s own markets.
This shift from free and open trade toward protectionism — not just in America but worldwide — coincided perfectly with Donald Trump’s ascension to the presidency. The study shows that trade liberalization across the globe halved from the 2010s economic expansion years before 2017 to the Trump years from 2017 to 2019. Tariffs placed on goods not just from China but also from Europe and other parts of the world spurred a backlash from America’s trading partners and caused protectionist ripple effects across the world.
A quintessential example was the European Union response in 2018 to Trump’s tariffs on European steel and aluminum. American tariffs on European products spurred retaliatory tariffs from Europe on American products like bourbon, blue jeans, and motorcycles.
A tectonic shift in the international trade equilibrium occurred, and that shift would be exceedingly difficult to undo. The Brookings Institute researchers conclude:
Worldwide the past three years have witnessed a profound shift away from the level playing field. Restoring the trading conditions of 2016 goes well beyond reversing the damaging tariff hikes by the American and Chinese governments.
In their view, the Phase One trade deal with China inked in late 2019 does nothing to reverse this new populist trade regime. It simply puts it on pause until a US president is ready to pick it up again. Indeed, at this point, it’s difficult to imagine what plausibly could reverse the trend of tit-for-tat trade wars. Even as market participants around the world demand more international trade, the political backlash against it, along with retaliatory ripple effects, scarcely seems to be fading.
Consider the upcoming presidential election. President Trump has promised to continue his crusade against China and others in order to re-domesticate manufacturing jobs. But would a President Biden be any more open to trade? Don’t count on it. Here’s Edward Alden writing in Foreign Policy:
If anything, Biden’s plans would likely make trade conflicts worse—at least in the short run. That’s because his showcase economic proposals include preferential treatment for U.S.-made goods, a long list of subsidies to domestic industries, and a ban on foreign companies from government procurement. These are exactly the kinds of protectionist practices that past trade agreements have sought to contain because they wall off home markets from foreign competition, are widely abused by governments and corporations, and often lead to a spiral of retaliation by other countries.
So, whoever wins the White House for the next four years, the weapons of trade warfare — tariffs, subsidies, tax breaks — remain sharp and ready to be used. They certainly have not been beaten into the plowshares of peaceful trade, despite this year’s surging trade deficit.
What’s Wrong With Trade Wars?
Contrary to the simplistic rhetoric that trade wars are easy to win, and that their primary effect is to bring back manufacturing jobs that have been outsourced overseas, reality is more complicated.
Protectionist trade policies tend to imagine a world in which international trade necessarily diminishes the total supply of jobs in one country in order to create jobs in another country. It also tends to imagine a world where each country fully produces a product, from start to finish, and then trades it across borders. Neither of these beliefs correspond well with reality.
In contrast to the idea that international trade diminishes the number of jobs, on net, in the country with a trade deficit, it could actually increase the number of jobs on a net basis. That is because, in contrast to the second idea above, all sorts of goods, from raw materials to intermediate goods to finished products, can be traded across borders. Implementing policies that disincentivize cross-border trade might be beneficial for some American businesses and industries that already manufacture most or all of their products in the States while also harming other American businesses and industries that assemble their products in multiple stages in different countries.
Giving American companies access to international markets by which they can lower their input costs can actually boost US manufacturing output and employment.
Over the last half century, manufacturing has become a global process for a large number of businesses and product types. Often, a product will cross borders multiple times before finally being finished and shipped to its end market destination. Alternatively, a finished product assembled in the US might have multiple component parts from different countries.
Protectionists often think that the only downside to their policies is a slight increase in consumer prices. Secretary of Commerce Wilbur Ross held up a can of soup in a TV interview near the beginning of Trump’s presidency, proclaiming that Americans would have to pay only an additional few cents for it to be made entirely in America. The American people would surely be willing to pay a few extra cents here and there in order to increase the number of US manufacturing jobs.
(Of course, the cost to American consumers is actually a lot more than just a few pennies. Steel tariffs, for instance, cost US consumers and businesses roughly $900,000 (or about 13 times the typical salary of a steel worker) for every American steel industry job saved or created.)
This reasoning, while well-intentioned, has been shown to be faulty by a 2019 Federal Reserve study that specifically analyzes the impact on the Trump administration’s tariffs. Here’s how a Fortune magazine piece summarizes the results of the study:
[Aaron] Flaaen and [Justin] Pierce’s research found that tariffs drove up the cost of inputs for American manufacturers. Combined with retaliation taken by trading partners, that led to a relative loss in manufacturing jobs and higher factory gate prices. Importantly, the study did not include the effects of trade-related uncertainty, which some economists believe has had the most significant effect on the U.S. economy by contributing to a stalling in business investment.
Or, as the researchers themselves conclude:
We find that U.S. manufacturing industries more exposed to tariff increases experience relative reductions in employment as a positive effect from import protection is offset by larger negative effects from rising input costs and retaliatory tariffs.
In other words, though some American manufacturers experienced a slightly positive impact from the tariffs, the net result was still negative for the sector. Here are Flaaen and Pierce again:
In terms of manufacturing employment, rising input costs and retaliatory tariffs each contribute to the negative relationship, and the contribution from these channels more than offsets a small positive effect from import protection.
…exposure to each of these channels of tariffs is associated with a reduction in manufacturing employment of 1.4 percent, with the positive contribution from the import protection effects of tariffs (0.3 percent) more than offset by the negative effects associated with rising input costs (-1.1 percent) and retaliatory tariffs (-0.7 percent).
If it wasn’t clear enough already, the researchers articulate that their findings “indicate that tariffs have been a drag on employment and have failed to increase output.”
Economic reality just isn’t as simple as protectionists would like to believe it is. One cannot quickly or easily disentangle a highly interwoven system of international trade without substantial and unmitigated costs. Flaaen and Pierce devote the final paragraph of their conclusion to this point:
In addition, our results suggest that the traditional use of trade policy as a tool for the protection and promotion of domestic manufacturing is complicated by the presence of globally interconnnected supply chains. While the potential for both tit-for-tat retaliation on import protection and input-output effects on the domestic economy have long been recognized by trade economists, empirical evidence documenting these channels in the context of an advanced economy has been limited. We find the impact from the traditional import protection channel is completely offset in the short-run by reduced competitiveness from retaliation and higher costs in downstream industries.
Another economic study from May, 2020 put out by the Federal Reserve Bank of New York looked at the effects of the US-China trade war on American firms and found detrimental effects on both returns on capital and investment rates. Their study found that
the trade war reduced U.S. investment growth by 0.3 percentage points by the end of 2019, and is expected to shave another 1.6 percentage points off of investment growth by the end of 2020.
While these numbers — 1.9 percentage points total over two years — may sound small, it should be noted that the study looked only at the effects of the US-China trade war, not any other tariff volleys with Canada, Europe, etc. The combined effect on investment of tariff battles waged over the past several years is surely higher. Moreover, the cumulative effect of around 1.6 percentage points less investment per year compounds exponentially the longer the trade war persists.
Another point to note is that this study comes on the heels of another study by the same authors demonstrating that US businesses bore virtually all of the cost of the tariffs on imports from China. In turn, these costs to American businesses “were almost completely passed through into US domestic prices in 2018, so that the entire incidence of the tariffs fell on domestic consumers and importers up to now, with no impact so far on the prices received by foreign exporters.”
In other words, the Chinese did not pay the tariffs. Americans did. To the tune of $8.2 billion in 2018 and at least $16.8 billion in 2019. Although the authors admit that this was a very conservative estimate, based only on tariffs enacted prior to 2019. More tariffs were layered on throughout 2019:
Source: New York Fed
A more recent study estimated the total amount of tariffs paid by Americans from February, 2018 to November, 2019 to be $46 billion.
In May, 2019, I wrote an article called “The Trade War Will Backfire On The American Economy.” In the article, I suggested that readers look “for backfire effects from the tariffs in the American economy, even in industries that ostensibly benefit from them.”
My fear back then seems to have borne out — the trade war did backfire, even on industries that should have benefited from it. This was the inevitable result, foreseen by thousands of economists, of economic protectionism.
The market clearly wants more international trade. After peaking at 30.8% in 2011, US trade (imports plus exports) slumped as a share of GDP during the 2010s economic recovery before, paradoxically, edging back up in the Trump years to 2018’s 27.5%. In 2019, trade jumped up to a record 31% of GDP.
U.S. Trade (Imports + Exports) As A Percentage Of GDP:
Source: Macro Trends
Far from being inflationary, as so many fear reshoring will be, it could very well be a disinflationary force in the long-term considering its negative effects on investment and real GDP growth. When a highly interconnected global economy wants more international trade, hindering such trade weighs heavily on its ability to grow.
Already, in 2019, growth in world trade volume (one of the primary drivers of economic growth) had sunk to around 0%. Now, in the first half of 2020, world trade has contracted more than at any time since World War II:
Source: Hoisington Investment Management Company, Q2 2020
As James Dale Davidson (over at WallStreetRebel) wrote last year, “High tariffs in the late stages of a credit-driven asset bubble are a recipe for triggering hyper-deflation.” And, indeed, deflation probably would have been the result of the tariffs and COVID-19 if not for huge fiscal stimulus measures (largely funded by the Fed) earlier this year.
As long as the pandemic persists and no new fiscal stimulus measures are enacted, the normal drop in real disposable personal income that happens during recessions will manifest, as pointed out by Eric Basmajian in his recent article, “The Waiting Game”:
Real Disposable Personal Income: Per Capita
Source: BEA; Eric Basmajian
If real disposable personal income drops below its trend growth line, the result will almost assuredly be mild deflation. Then again, all more fiscal stimulus can do is either (1) pull forward future consumption to today or (2) redistribute resources from investment to immediate consumption. Either option, or any combination of the two, would deprive the US economy from future growth for the sake of short-term pain mitigation.
So, in short, the continuation of this tectonic shift in global trade is likely to reduce corporate profitability and/or real personal incomes (via marginally lower manufacturing employment), economic growth, and investment. This, combined with a massive public and private debt burden, will likely make the economic recovery coming out of the COVID-19 recession even slower than the historically slow recovery coming out of the Great Recession.
It also means that, as in the expansion following the GR, inflation should remain muted and unable to hit the Fed’s 2% target. Since long-term interest rates are largely a function of inflation expectations, long-term rates should remain muted as well — except for a short period coming out of the current recession when the pandemic fades in importance, due to falling case count growth or a vaccine or some other reason, at which point I expect a brief and modest rise in inflation expectations and rates.
I continue to favor business models with long-duration, contractually-fixed revenue streams based on real assets. Examples include midstream natural gas pipeline corporations (e.g. the Global X MLP & Energy Infrastructure ETF (MLPX)), net lease real estate investment trusts (e.g. the NETLease Corporate Real Estate ETF (NETL)), and general infrastructure (as in Brookfield Infrastructure (BIP, BIPC)) or utility-scale renewable energy (as in Brookfield Renewable (BEP, BEPC) or Clearway Energy (CWEN, CWEN.A)).
These companies will benefit from muted inflation and ultra-low interest rates, both because yield-starved investors will be drawn to their dividend yields and because they typically make ample use of debt capital.
I know regular readers of mine are probably tired of hearing me repeat the same investment suggestions over and over again. My philosophy is that if you have one really good investment idea, you’re probably better off than most investors. So why try to be clever with your hard-earned money?
We at High Yield Landlord don’t want to be clever. We want to be wise, investing in high-quality, high-yielding real assets (mostly real estate) that will safely and predictably make us richer over time.
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Disclosure: I am/we are long MLPX, NETL, BIP, BIPC, BEP, BEPC, CWEN, CWEN.A. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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