Flash Note US trade policy update Steel-ing the show

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1 FLASH NOTE Flash Note US trade policy update Steel-ing the show The effect of new tariffs is more micro than macro. But they carry risks. Pictet Wealth Management - Asset Allocation & Macro Research 6 March 2018 President Trump wants to impose tariffs of 25% on imports of steel and 10% on aluminium. Details are still to be thrashed out. The Trump Administration sounds determined to carry out a more aggressive trade agenda, increasing the risk of retaliation from the US s trade partners. For now, we believe that the new tariffs impact is more micro than macro. We are keeping our US growth and Fed forecasts unchanged. That said, further escalation in US trade rhetoric and further unilateral moves on trade protection would lead to an alternative downside growth scenario. US President Trump wants to impose trade tariffs of 25% on imports of steel and 10% on aluminium, although the formal announcement and the exact details are yet to be released. The basis for this move is officially national security, although it is clear that there are also internal political considerations at play. More trade protection was a key Trump campaign promise, resonating in industrial swing states like Ohio and Pennsylvania. The tariffs have more a micro (i.e. industry specific) than a macro impact for now, in our view. But they could still raise medium-term risks to growth, if they were followed by further trade restrictions and a worsening business environment. How business confidence evolves will indeed be key. Higher uncertainty on trade policy goes against the benefits of recently enacted tax cuts. Trump s tariff move could also revive fears that Trump s populism goes beyond rhetoric. It is possible that Trump s decision may be followed by trade tariffs to protect other sensitive industries, like car manufacturing. There is also the risk of retaliation from trade partners, with more tit for tat tariffs possible, and even the tail risk of a trade war. However, our core scenario is that US trade rhetoric will be contained, as corporate lobbies and the pro-trade Republican Party leadership maintain pressure on the Trump Administration. Also, we believe Trump will stay sensitive to the potential downside risks he may create by his tariffs. Chart 1: Top five exporters of iron and steel articles to the US (HTS 73) AUTHOR Thomas COSTERG tcosterg@pictet.com Pictet Group Route des Acacias 60 CH Geneva Total imports of articles of iron or steel (HTS 73), in USD bn China Mexico Canada Taiwan S. Korea HTS: Harmonized Trade System categorization Source: Pictet WM-AA&MR, US Int l Trade Commission.

2 Pick-up in the Trump Administration s protectionist rhetoric Donald Trump s anti-trade rhetoric was a key theme of his campaign platform and the one that put him most at odds with the Republican Party line. At points during the 2016 presidential campaign, Trump spoke about placing blanket tariffs of 45% on all imports from China, and of 35% on imports from Mexico although his crucial speech about foreign trade in Monessen, Pennsylvania on 28 June 2016 did not mention them. That speech, however, still showed that Trump was ready to make a break with some aspects of laissez faire US trade policy. In the Monessen speech, he mentioned seven steps to be taken on trade policy, including renegotiating the North America Free Trade Agreement (NAFTA, currently in progress) and, more importantly, becoming more assertive with China. Trump threatened to label China a currency manipulator (which, so far, has not happened) and to bring trade cases against it both in this country [US] and at the WTO (World Trade Organisation) (so far, the US Trade Representative has opened an investigation into China s trade practices, focused on intellectual property issues). The good news is that Trump has not applied the most extreme and demagogical proposals he talked about during the campaign including his threat to withdraw from the WTO. But the recent trade measures on steel and aluminium do raise the fear that a more protectionist trade policy is now on the cards, especially as the tax cuts are now a done deal, freeing Trump s hands to focus on this other populist elements of his presidential programme. The tariffs might also indicate that the Trump Administration is ready to be more assertive with China, even though Trump did not specifically target China. Key to understanding the decision is that the US trade deficit remains a front and centre worry for President Trump. He is of the view that more protectionist policies are needed to stem the ongoing rise in imports, especially from China (see Chart 2). Chart 2: US monthly trade deficit, 12-month moving average Trade deficit with China -40 Deficit ex oil -50 Total deficit (including oil) -60 Monthly deficit, in USD bn -70 (12-month moving average) Source: Pictet WM-AA&MR, US ITC.

3 He believes that the global trade system is unfair as some countries (and chiefly China) subsidise directly or indirectly their companies, putting their US rivals at a disadvantage. Trump denies he is a protectionist. Instead, he says he believes in fair trade, citing Ronald Reagan s precedents on trade policy in the 1980s. Indeed, Reagan did place quotas on auto imports from Japan, which was then a rapidly growing economy and booming exporter, and slapped tariffs on semiconductors (of up to 100%) and motorcycles (up to 45%). Trump could also cite the more recent precedents set by George W Bush and Barack Obama, who also set industry-specific tariffs including temporary tariffs on steel imports under George W. Bush. Still, Trump s measures on metals come hot on the heel of tariffs on solar panels and washing machines (from Asia), introduced only a few weeks ago. They also come as the trade hawks within the Trump Administration a trio made up of Wilbur Ross, Robert Lighthizer and Peter Navarro seem to be gaining more influence at the expense of pro-business, pro-trade officials like Gary Cohn, a former Wall Street investment banker. In other words, a lot of signals are pointing in the wrong direction. Critics would say that Trump risks undermining his economic agenda, not only because of the potential retaliation from trade partners (including close allies), but also because of the potential hit to GDP if market or business confidence starts to erode. Many critics would also argue that Trump is fighting yesterday s war by focusing too much on the manufacturing sector and particularly on the steel sub-sector and not enough on education, technological change, or the sectors of the future (anyway, some argue, robots will take the place of factory workers, trade protectionism or not). Crucial details awaited: Canadian or Chinese steel? As we write, Trump still had to thrash out the details of his hasty announcements about steel and aluminium, which surprised many advisers and lawmakers in the Republican party. The key question is how carefully conceived and targeted the trade tariffs are. If not well crafted, there could be serious side effects. Tariffs could fall disproportionately on the US s Canadian neighbour, for instance. Chart 3: Top five exporters of iron or steel to the US (HTS 72) Total US imports of iron or steel (HTS 72), in USD bn Canada Brazil Russia Mexico Germany HTS: Harmonized Trade System categorization Source: Pictet WM-AA&MR, US ITC.

4 Regarding steel in particular, the question is what sort of steel is caught in the new tariffs net. With a value of USD 5.2bn, Canada dominates US imports of raw steel (Chart 3), followed by USD 3.0bn of imports from Brazil and USD 2.5bn from Russia. But it is another story for processed steel, where China clearly dominates trade flows (Chart 1), exporting USD 11.5bn worth to the US in 2017, well above Mexico s USD 4.5bn and Canada s USD 3.9bn. By comparison, imports of Swiss watches into the US totalled USD 2.7bn in In a recent tweet, Trump said that NAFTA partners could be spared from the measures on steel if they agreed to the US s demands on renegotiating the NAFTA treaty. This gives the impression that Canada and Mexico are not the direct target of these measures, which could be diluted down the road by crafting exemptions. Also, apart from the country exemption question, there is still the possibility that companies could apply for leniency on a case-bycase basis. Chart 4: Top five aluminium exporters to the US (HTS 76) Total imports of aluminium (HTS 76), in USD bn Source: Pictet WM-AA&MR, US ITC. What next? Watch the US-China trade relationship Canada China Russia UAE Mexico The trade measures show not only the political (and symbolical) importance of the domestic steel industry, especially with regards to President Trump s political base, but also could potentially signal a more assertive stance towards China. This will need to be monitored closely since specific measures against China s imports could bring sizeable disruption to US supply chains, and therefore to its economy. Articles of steel (Harmonized Trade System category 73) do make it into the top 10 of US imports from China, but they are dwarfed by electronics like cell phones and laptops/tablets (See Chart 5). Imports of Chinese-made cell phones and related items (HTS 85) amounted to USD 147.0bn in 2017, up an average 5.8% per annum in the past five years. The question is therefore whether the Trump Administration starts to look at these categories, which would have a much considerable bite than processed steel. It is possible imports of electronics could come into focus in the coming months, especially in light of the current investigation into

5 China s intellectual-property practices. This investigation, led by US Trade Representative Robert Lighthizer (who also helped craft tariffs for the Reagan Administration), started in August 2017 and could take up to a year before concrete actions are taken. Chart 5: US imports from China: fabricated steel dwarfed by electronics 160 5Y CAGR, %, RHS 10% 140 8% 120 6% 100 4% 80 2% 60 0% imports from China (USD bn), LHS -2% 20-4% 0 Electronics: cell phones (including Iphone) (85) Electronics: tablets and laptops (84) Apparel and clothing (HTS 61, 62, 63) Furniture (94) Toys (95) Plastics (39) Car parts (87) Footwear (64) Precision instruments (90) Articles of iron and steel (73) -6% (Note: at the HTS 2 level) Source: Pictet WM-AA&MR, US ITC. Still, our base case is that trade tariffs remain industry specific, (echoing what happened with Ronald Reagan s 1980s trade policy) and that they have more of a micro than a macro impact. We do not believe that there will be blanket tariffs on all imports from a given country such as China. The fear of a market correction especially since Trump has tied his political fortunes so much to the stock market likely mitigates the possibility of any sharp escalation in Trump s trade rhetoric, in our view. Corporate lobbies, including importers and those involved in complex global supply chains, as well as the Republican Party leadership, are also likely to spring into action and limit the reach of the tariffs or any further trade protection measures. Chart 6: Top 10 countries with which the US has a trade deficit (merchandise trade) Trade deficit in goods, USD bn (2017) China Mexico Japan Germany Vietnam Ireland Italy Malaysia India Korea Source: Pictet WM-AA&MR, US ITC.

6 If, however, US trade rhetoric were to escalate further, and the US s trade partners were to retaliate more forcefully, there could be downside risks to the growth outlook not only because of the impact on supply chains but also due to the potential hit to business confidence and decreased visibility. While we prefer to remain relatively sanguine, the details of the new tariffs on steel and aluminium will provide a first impression on the direction of travel in terms of Trump trade policy whether we stay at the micro level or whether we start to migrate, more worryingly, to a kind of protectionism that has a macro impact. For now, we are keeping our core 2018 US GDP growth forecast of 3.0% (up from 2.3% in 2017) and our forecast of four Fed rate hikes this year as we expect trade rhetoric to stay contained, while underlying momentum remains solid. We recap recent US trade-related policy actions in the table at the end of this Flash Note. Chart 7: Employment in selected manufacturing sub-sectors in the US Total employment (mn people) Fabricated metal product manuf. +3.1% y-o-y Motor vehicles and parts -0.2% y-o-y 0.6 Primary metal manuf % y-o-y Source: Pictet WM-AA&MR, Bureau of Labor Statistics.

7 US TRADE POLICY: KEY ITEMS AND RECENT UPDATES NAFTA (North America Free Trade Agreement) Targeted trade tariffs China WTO (World Trade Organization) The announcement of trade tariffs on steel and aluminium are seen as a further stumbling block in the current NAFTA renegotiations, especially since Mexico and Canada have sizeable bilateral trade flows with the US in metals. Recently, as a way to pressure the US s partners, President Trump said that there could be a tradeoff between NAFTA renegotiation and being exempted from the tariffs on steel. After being long a key focus in the early stage of his mandate, President Trump s stance on NAFTA seemed to soften in recent months, perhaps reflecting a growing awareness of the political and geopolitical context (in particular the Mexican elections on 1 July). Also, the window of opportunity in the US Congress to validate the agreement has all but shut ahead of the 1 November midterm elections in the US. The most likely scenario is therefore that the talks could stall and reopen later in the year, if not next year. The next round of talks is planned for early April in Washington DC. President Trump seems also to have become more sensitive to the agricultural lobby lately (in agricultural commodities, the two other NAFTA countries are important export markets for the US) The two main sticking points regarding NAFTA renegotiation (and red lines for both Mexico and Canada) are the sunset clause, which would automatically terminate NAFTA unless it were reapproved in all three countries legislature, and the increase in NAFTA content requirements: the US wants to increase the share from 62.5% to 85% (i.e. 85% of a product must come from NAFTA to come into the US tariff free), with a new specific threshold of US-origin content of at least of 50%. The White House has potentially the authority to withdraw from NAFTA (although this is still debated by legal scholars), but our base case is that Congress, which is more pro trade (and pro NAFTA) than Trump is, would reinstate the treaty in such an extreme event. Unilateral action on trade risks creating a deep split between Trump and the Republican Party, in our view, at least during the life of the current Congress. The trade tariffs on steel and aluminium come on top of trade tariffs on washing machines and solar panels officially introduced on 22 January These tariffs, which rise to as much as 50% for washing machines beyond a certain quota, mostly affect South Korean and Malaysian imports. The US formal investigation into China s trade practices is a sword of Damocles hanging over US- China trade relations. Investigations into trade in intellectual property were opened by the US Trade Representative in August While no formal deadline has been set (according to various media reports, it could take a year), the investigation could open the door for several punitive measures against China, including further sanctions. The question is whether tariffs could fall on electronics imports. The Committee on Foreign Investment in the US (CFIUS), which reviews acquisitions by foreign entities for potential national security risks, is widely seen as having adopted a stricter approach under the Trump Administration than before, blocking several deals in recent months. In particular, CFIUS blocked a high profile deal in the money transfer business in January It also blocked a bid for a California-based chipmaker in March A bill in Congress proposes to expand CFIUS s reach to include monitoring of activities at joint ventures with US companies abroad and to lengthen review times. China is included in the US Treasury s Monitoring List for currency manipulation, along with Japan, Korea, Germany and Switzerland (as of the last semi-annual Treasury report of October 2017). Since Trump s election, the US has been vetoing the appointment of new judges to the WTO s Appellate Body (The WTO court that hears global trade cases). One of the WTO judges will retire in September, leaving a further seat empty. Staff shortages could ultimately lead to the court s paralysis. Trump said in a February meeting that he considers the WTO a catastrophe ( we lose the cases, we don t have the judges ).

8 Tax policy / V.A.T. (Value Added Tax) / B.A.T (Border- Adjustment Tax) Personnel/ Nominations The controversial BAT idea, championed by the Republican Party leadership, including House speaker Paul Ryan, was eventually abandoned in July 2017 and did not make it into the December 2017 tax bill. Put simply, the BAT, compared to a destination-based cash flow tax, would tax imports but exempt exports similarly to a VA- based system. Some saw it as a way to respond to other countries VAT systems while others saw it as a protectionist trade measure. The December 2017 tax bill, the highlight of which was a drop in the statutory corporate tax rate from 35% to 21%, was partly aimed at improving the US s global tax competitiveness and luring more foreign businesses to the US, with the hope also of curtailing imports. The bill created two new taxes the Base Erosion Anti-abuse Tax (BEAT) and a Minimum Tax on Global Intangible Low Tax Income (GILTI) to curb aggressive corporate fiscal planning and profit shifting to low-tax jurisdictions outside the US. Some imports could be accounted differently going forward, helping reduce the US trade deficit, although it is not clear to what degree. Recently, there have been reports that the BAT concept is resurfacing among White House staff (cf Politico, Feb ). This is something worth monitoring. In the long run, it is not hypothetical to believe some sort of federal value-added tax could be implemented in the US, not only because it is a system now applied in most other countries, but also because the US will be in need of tax revenues, especially to finance growing social spending. In late February 2018, Peter Navarro, author of Death by China (among other books), was promoted to the position of assistant secretary to the President (he has previously deputy assistant). This promotion was widely seen as reflecting the rise of the trade hawks influence within the White House. Source: Pictet WM-AA&MR, Media

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