Global Trade War - What It Would Do To The Economy

Global Trade War - Tight Labor Versus Margins

Global Trade War - The labor market is relatively tight, although the prime age labor force participation rate is still below the previous 3 cycle peaks. The relatively tight labor market hasn’t led to heightened inflation. April core CPI was only 2.07%. That has allowed the Fed to avoid anymore rate hikes which would further invert the yield curve. 

As you can see from the chart below, analyst research reports haven’t mentioned margin pressure much even though the labor market has been tightening. In fact, as the mentions of the tight labor market have increased, margin pressure mentions have fallen.

To be clear, you’d expect higher labor costs to hurt margins. Some firms are more labor intensive than others and industries have varying labor market dynamics, but labor is a cost for every firm and wage growth is higher than it was earlier in the cycle. I’m working under the assumption that the average weekly wage growth decline in April was a one-off event. The spike in jobless claims, which could also be temporary, supports the thesis that the labor market is weakening. 

It’s not as if this chart is inaccurate when it comes to margins. They are cyclically high.

FactSet’s Q1 earnings insight shows margins falling because sales grew faster than profits.

Earnings Scout data shows the opposite dynamic.

Finally, the chart shows the mentions of automation in analyst notes. I’m not 100% sure why there was a big spike prior to 2014. I’m speculating that the rise in 3D printing hype caused this. Those stocks peaked in late-2013. That was a major bubble. 

People who didn’t understand the technology believed everything would be 3D printed. The projection of consumers having a 3D printer in their homes to print whatever they want hasn’t come to fruition about 5.5 years later. The increased use of automation this time isn’t based on a fad. Automation could be most useful in a tight labor market because labor is tough to acquire and comes at a relatively high price. 

With the employment to population ratio for those without a high school degree near its record high, there is no better time to replace workers with automation.

Inflation Not As High As You’d Expect

Global Trade War - The abor market hasn’t catalyzed heightened inflation. The chart below shows acylical and cyclical inflation. 

As you can see, cyclical inflation is lower than it was at the end of the past 3 cycles. Acylical inflation certainly isn’t helping the situation as it is relatively low compared to the past 30 years of data.

Recently, Powell mentioned the weakness in portfolio services inflation, clothing/footwear inflation, and air transportation inflation. In the March PCE report, they had impacts on core PCE of -2 basis points, -7 basis points, and +1 basis point. Powell called these factors all transitory. 

Powell mentioned how apparel had a new methodology and how portfolio services inflation would soon spike because the market has rebounded (the effect is delayed).

He’s probably wrong to expect core PCE inflation to reach 2% and stay there any time soon because in the April CPI report prices for airfare and apparel fell. Those are small impacts on the report anyway. Keep in mind, core PCE is usually below core CPI and core CPI was 2.1%. If shelter inflation is at all hurt by the big decline in home price growth, we could see core inflation plummet sharply. 

The last time shelter inflation was higher than Case Shiller yearly home price growth was August 2012. The Case Shiller reports from March and April might show this happened again.

Trade War’s Effect On Core PCE Inflation

As you can see from the chart below, the impact of tariffs on core PCE would be declining quickly without this latest increase in tariffs. 

Now the positive effect of slightly less than 0.2% will remain a few months longer. The most updated PCE report is from March, so there are quite a few more reports for tariffs to lift. April PCE report will be released on May 31st. The dark blue line in this chart isn’t going to happen since it’s highly likely the tariffs will still be in place by May 31st when the first ships from China land in America and are forced to pay the 25% tax.

Global Trade War - With the way the negotiations are going, we need to worry about President Trump putting all Chinese exports under the 25% tax rate. If that happens, the impact on core PCE could be above 0.3%. Before you start to expect 2% core PCE inflation, keep in mind it was only 1.6% with tariffs boosting it by 0.2%. 

If the tariffs are removed in 2020, it could serve as a great way to limit inflation as the economy recovers and generates more cyclical inflation. To be clear, I’m not 100% sure the economy will recover next year and I’m even less certain about when a trade deal, which eliminates the tariffs on China, will be struck.

Global Trade War

The chart below shows what would happen if this bilateral trade war between America and China turns into a global trade war. I know many people said a trade war of this nature with China was unlikely and it happened. However, that doesn’t mean every unlikely terrible trade event will happen. I don’t think there’s much of a chance we will see a global trade war, but it’s important to understand what would happen.

When you understand the worst case scenario, you can figure out where stocks should be priced. For example, if stocks fell 10% and you calculated they are pricing in a 25% chance of global trade war, it would make sense to buy stocks because that’s an unlikely event. 

As you can see, a global trade war would hurt American GDP by 2.1%, Chinese GDP by 2.5%, and global GDP by 1.7%. American GDP growth would assuredly be negative in 2020 and the global economy would be in a deep recession. 

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