Beware the Politics of Deficits and Trade
Growing US fiscal deficits could not only accelerate the pace of interest rate hikes, but also generate turmoil where they intersect with the politics of trade.
Even as we shift away from the age of easy money, central bank decision-making will rightly continue to hold the market’s attention. But there is a pernicious policy feedback loop that could hold nasty surprises for investors. Monetary policy does not operate in a vacuum, and in the wake of the latest budget decisions in the US, there is growing recognition that the resulting, massive build-up in US fiscal deficits could accelerate the pace of interest rate hikes. Less acknowledged is the potential turmoil those fiscal deficits could cause when they intersect with the politics of trade.
As fiscal deficits widen in the mature part of an economic cycle, additional fiscal stimulus cannot be absorbed by excess slack in the domestic economy. As a result, the stimulus is exported through higher import demand. Furthermore, fiscal expansion at this stage also leads to inflationary pressures, pushing monetary authorities to raise interest rates to combat inflation, thereby boosting the purchasing power of the home currency. The end result is usually higher trade deficits. In a different era, this economic linkage would be the end of the story.
Fiscal Deficits Exacerbating Trade Deficits
In 2017, the Trump administration actually enacted fewer trade discriminations than the Obama administration in 2016, but 2018 is shaping up to be the year Trump gets serious about trade. In March, Trump announced sweeping tariffs on steel and aluminum, then swiftly extended the campaign to intellectual property disputes with China. We believe the incentives for the Trump administration to ramp up trade confrontation will be amplified by the policy loop outlined above. Fiscal policy will indirectly exacerbate a politically sensitive metric — the trade deficit — and this during a midterm election year and creeping judicial investigation.
In addition to broad tariffs, we see the potential for targeted escalation of trade relations. The central arena this year continues to be the US-China dynamic and North American Free Trade Agreement (NAFTA). In contrast to rising US-China risks, we believe that NAFTA will undergo only limited or cosmetic changes. While dismantling NAFTA’s “bad deal” was central to Trump’s campaign, nine of the top ten NAFTA trading states voted for Trump and the overall NAFTA trade deficit is less than a quarter of the US-China imbalance (see Figure 1). Trump’s behavior during the tax reform negotiations also suggests how he will operate with trade. Ultimately, the most controversial tax measures (for example, capping the deductibility of state and local taxes as well as mortgage interest deductions) were tilted toward Democratic-leaning states.
China Trade War Risk
In stark contrast, the bilateral US-Chinese trade relationship is now inextricably bound up with the two countries’ wider geopolitical rivalry. Consequently, there is a greater chance of disruption as non-economic policy considerations increasingly shape key decisions. This bodes poorly for the coming year as non-economic relations are more confrontational, implying rising trade frictions. To make matters worse, the US political economy makes this outcome more likely: the US bilateral trade deficit with China accounts for over 60% of the overall US trade deficit and US exports to China are diffused across the country. Compounded with midterm congressional elections in November, the political incentives for the Trump administration are significantly in favor of escalating trade disputes. The current strong headline growth figures in the US obscure the underlying reality of growing income disparities in which lower-middle income groups are falling further behind and fueling a populist backlash. Given that Trump’s domestic agenda fails to address those economic struggles, at least part of his foreign policy will need to acknowledge the anti-globalization bent of his base.
In the event of a US-China trade war, exporters in both countries are obvious losers. However, import demand is rarely substituted by domestic producers and typically would draw on third-country providers. Looking at the US-China trade imbalances, Chinese consumer and capital goods are responsible for 94% of China’s surplus, making those goods most vulnerable to US punitive action. Chinese producers could therefore be ceding market share to Southeast Asian or European competitors. In contrast, the US surplus is mainly in food and service exports, with the former most easily targeted for substitution, presumably to the benefit of Latin American or European competitors.
The extent of the fallout will likely be a function of China’s preparedness to offer compromises. The leadership’s stated desire to rebalance the economy and China’s reduced dependence on this trade surplus does give them more leeway in 2018 than in previous years. In other words, the best outcome would be a skilful Chinese maneuver that aligns its economic reform priorities to deflect US demands. Beijing is planning to open certain sectors (for example, financial and select technology sectors) to increased foreign participation where US firms have a competitive advantage. China could use the timing of such openings to inject greater US market access, which would naturally improve the trade balance. In sum, while increased US pressure appears inevitable, a mutually beneficial and pacifying outcome remains possible in 2018.
As for the US trade imbalance with the European Union (EU), it is the second largest after China. While US tax reform includes provisions that should structurally support increased US exports to Europe, Trump’s steel and aluminum tariffs have already provoked EU assurances of retaliatory measures. Even if US-China trade relations deteriorate, that is unlikely to alter the overall US current account deficit, which is a macroeconomic function of an imbalance in savings and investment.
That imbalance brings us back to US fiscal policy, which will be the primary driver of "dis-savings." The US federal budget will quickly start to feel the effects of a deficit estimated to grow to roughly 4% of GDP in 2018, and rising far above 5% of GDP from 2019 onwards. This equates to roughly USD 400 billion to USD 500 billion more in annual issuance of US government securities just to fund the government shortfall. At this stage of the economic cycle, that could accelerate the increase in bond yields in addition to monetary tightening. Such high deficit levels in the late stages of an economic cycle could also undermine confidence and, once the sugar rush of the recent tax cuts has worn off, dent investment as expectations of future tax increases grow. For example, the 1981 Reagan tax cuts were followed by five distinct tax increases in the subsequent decade — and debt levels were roughly half what they are now. The other risk is that larger public debt issuance could begin to crowd out private sector borrowing, all of which could begin to slow the economy. At that stage, perpetually higher trade deficits could further amplify calls for tougher action and further undermine the case for cooperative globalization. Trade rhetoric is fast becoming one of the more important market signals for investors in 2018.