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Car tariffs could mark turning point for global growth outlook

Retaliation from trading partners will affect inflation and car industry employment.

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According to JP Morgan, the US imported US$360 billion of cars and car parts in 2017 - and only 46 per cent of US final demand for cars is sourced domestically.

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The writer is chief investment strategist at LGT Bank Asia.

FINANCIAL markets are rapidly coming to terms with a number of unprecedented policy developments from the Trump Administration, that have potentially far-reaching impacts with both pro-growth and dampening implications.

On the former, corporate and income tax cuts enacted shortly after the election are propelling the US economy to grow well above trend. The current economic expansion is the second-longest on record (dating back to 1854), and combined with the drive to reduce regulation, it can be argued that US President Donald Trump has given the maturing economic cycle a boost that may see it break earlier records.

Hence US unemployment may hit 3.5 per cent towards the end of cycle, and real wages are expected to continue rising at a moderate pace, leaving the door open for the US Federal Reserve to continue hiking interest rates. Stock markets cheered these early initiatives, especially in January, as it became clear that corporate earnings growth in the US was likely to see a substantial boost, underpinning above-average valuations.

It is important to bear in mind that during the election campaign, Mr Trump was vocal about his intention to cut taxes and repeal regulation that, in his view, restricted business growth. On this front, he has largely delivered his election promises.

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Since January, however, equity markets are markedly lower, and bond yields have increased substantially. At the same time, the US dollar has appreciated against most currencies, arguably reinforcing capital outflows from emerging markets (EM), forcing some EM central banks to hike rates to defend their currencies and bolster their inflation fighting credentials - at the expense of slower EM growth. In short, it would seem that something has gone wrong.

In retrospect, we can posit that financial markets may have been too quick to discount some of Mr Trump's campaign promises, while taking other intentions at face value.

The greatest misperception in this regard is arguably on trade policy. As a candidate, Mr Trump promised to take a more hawkish stance on trade, but perhaps the market did not anticipate the extent to which the White House would be following through with this new approach.

The first set of import tariffs was set in February, on a limited range of goods such as solar panels and washing machines. Most orthodox economists would take the line that the tariffs are disruptive to trade and normally harm the consumer faced with an artificial price increase that often cannot be avoided. This is because, especially in the short run, alternative products not subject to tariffs are unavailable, so the consumer has to decide whether or not to buy the product with the tariff.

As anticipated, the impact of the February tariffs are showing up in US Consumer Price Index (CPI) data - the price of washing machines has jumped as of the end of May, as US consumers choose to pay the tariff.

While this is an example of a single good, the Trump Administration has signalled its willingness to expand tariffs to a wide range of goods, which is perhaps why financial markets have become increasingly nervous over the past few months. Washing machines are not a significant component in the overall CPI in the US, but as the scope of tariffs widens, the general price level can be expected to rise, posing a complicated challenge for the Fed.

Currently, the Fed is hiking interest rates because growth is above trend, capacity utilisation is high, and wages are rising. Indeed, real interest rates are still negative in the US, so it cannot be argued that the Fed's policy is especially restrictive. Rates are rising, but at a gradual pace that appears to echo the pick-up in inflation pressures.

What would happen if tariffs were to become widespread? If the washing machine example is illustrative, then the overall CPI may accelerate, forcing the Fed to decide whether faster rate hikes are needed, or to 'sit it out' and argue that tariff-driven inflation can be tolerated. If rates rise faster, then it is conceivable that the current economic expansion may come to a quicker end, with potential for equity markets to correct substantially.

If the Fed chooses to look through the possible CPI jump, bond yields may rise anyway, thus tightening financial conditions. The market's focus will then be squarely on the Fed as the US government is substantially increasing its fiscal deficits (due to the tax reform) and therefore does not have much 'space' to smooth out the onset of slower growth (or even a recession) as financial conditions tighten.

What could bring us to this point?

In short, the most likely trigger for a meaningful increase in the path of US inflation would be the 25 per cent tariffs on imported new vehicles and car parts.

According to JP Morgan, the US imported US$360 billion of cars and car parts in 2017 - and only 46 per cent of US final demand for cars is sourced domestically. At the same time, the US exported US$158 billion of cars and car parts - 7 per cent of total US exports. New vehicles form 3.8 per cent of the US CPI basket and 4.8 per cent of the core CPI measure, as well as 0.6 per cent of total non-farm employment.

Putting this together, if the US applies 25 per cent tariffs on cars and car parts, and assuming that trading partners retaliate with an equivalent tariffs, the inflation impacts and likely risks to US car industry employment will be significant.

The US is expected to hold public hearings on the topic of car tariffs in late July. We take the view that trade tensions and ensuing tariffs up to now do not pose a material risk to US or global growth outlook - but investors should be mindful that this could change depending on future developments on the car sector.

  • The writer is chief investment strategist at LGT Bank Asia