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.