Markets Create Their Own Reality - The Wall Street Journal

A container ship unloading its cargo in Long Beach, Calif., last week. The tariffs so far are pretty small beer for the U.S. economy. Photo: mark ralston/Agence France-Presse/Getty Images

By

James Mackintosh

James Mackintosh
The Wall Street Journal
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• james.mackintosh@wsj.com

Updated May 17, 2019 12:31 a.m. ET

Stock markets are often accused of living in an alternate reality, but to analyze the trade war with China you have to accept the truth: Stock markets make their own reality.

For the past two weeks that reality has been pretty unpleasant. Three-quarters of stocks in the S&P 500 as well as 95% of stocks in Goldman Sachs ’s high China exposure list are down since President Trump made clear in tweets earlier this month that the trade war was back on. Bond yields have also tumbled.

All this makes a lot of sense. U.S. tariffs on Chinese imports went up, when markets expected them to go down, and Mr. Trump says they might be applied to all Chinese goods if no deal is reached soon. That means higher prices, lower profits and a slower economy.

But just how bad will it be? On the face of it, the tariffs so far are pretty small beer for the U.S. economy, even at their new 25% rate. The tariffs amount to a tax of about $70 billion, including the steel tariffs. That isn’t great for the U.S., but even if none of the pain is passed on to China—and evidence suggests that so far it is Americans who are paying the extra costs—it amounts to 0.3% of the $21 trillion of spending in the economy.

If Mr. Trump goes ahead and extends the tariffs to the remaining Chinese imports, that could amount to an additional $75 billion or so of tax, about an additional 0.3% of GDP. That’s starting to hurt if it is all passed on to U.S. businesses and consumers. But it won’t be.

First, companies will switch to alternative sources of imports, reducing the extra cost. The longer the tariffs last, the more supply chains will move to other countries. Second, customers will switch spending to other types of goods altogether if prices go up too much, benefiting U.S. producers. Third, Chinese companies might lower prices (although there’s no sign of significant reductions so far), and the yuan might be allowed to weaken, helping lower prices in dollar terms.

Goldman Sachs chief economist Jan Hatzius estimates the overall hit to the U.S. economy is 0.15 percentage point from the tariffs announced so far, rising to 0.25 point if tariffs are extended to all Chinese goods. Compared with 3.2% GDP growth in the first quarter, it might seem odd that the S&P 500 had its worst six days since the recession panic in December, and that futures markets now think a Federal Reserve rate cut this year is more likely than not.

There are two ways to see the market reaction. The first is to dismiss it, on the grounds that even at this week’s worst point the S&P 500 was only 5% below its all-time high. Markets aren’t panicking, yet.

The second is to recognize that the market is a bigger danger to the economy than the direct effect of tariffs. If the markets go into a tailspin, the hit to confidence hurts more than the tax. So if markets fear that tariffs will hit hard, they will.

“These effects are difficult to model,” says Barclays ’s head of economics Christian Keller. “They can be self-reinforcing and so larger than the pure mechanical model estimates of the first-order effects of tariffs.”

Goldman tries to gauge broad financial conditions to estimate these confidence effects; Mr. Hatzius says the impact of the market moves since Mr. Trump’s tweets two weekends ago is slightly bigger than the direct effect of the tariffs, but it can change quickly.

The danger is that markets create a reality that is far worse than the current one—perhaps because the rhetoric about geopolitical rivalry with China convinces investors that a new cold war is on the way. If the trade war isn’t merely an isolated incident, then broader risks should be priced in, meaning lower stock prices that hurt CEO and consumer confidence, and then the economy.

It doesn’t have to be doom and gloom, though. Markets created their own reality in Britain after the Brexit vote in 2016. After a brief tumble, stock prices rebounded, business investment stayed firm, and consumers kept shopping. Only later, once the political mess the country had landed itself in became impossible to ignore, did spending decelerate.

Economists had expected an immediate hit to confidence with a knock-on impact on the British economy. When it didn’t immediately appear, economists’ reputations took a bigger hit than GDP.

The feedback loop isn’t just from the markets to the economy. The talks have their own fragile reality, too, and the markets can interfere. Mr. Trump blamed Chinese attempts to back out of previous offers for his extra tariffs, but his decision to get more aggressive also came after markets had recovered, strengthening his hand in the talks.

If U.S. stocks create their own darker reality and plummet, it will pressure the U.S. side to agree to a deal to stem the fall. Indeed, the drop might already be having an effect, with the threat of tariffs on European and Japanese cars on hold and Mr. Trump making more positive noises about the China talks—helping the market bounce as its perception of reality has grown rosier.

Write to James Mackintosh at James.Mackintosh@wsj.com

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https://www.wsj.com/articles/reality-is-intruding-into-markets-11558028396

2019-05-17 04:31:00Z
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