U.S. trade policy has evolved significantly in a matter of weeks. Most recently, many observers are interpreting the Trump administration’s ongoing changes to tariff policy, including delays, negotiations, and exemptions, as potentially tempering the overall disruption to the U.S. economy. Consistent with this sentiment, U.S. equity markets have recovered somewhat after their initial reaction to the 2 April announcements. The S&P Index, for example, was down roughly 9% as of 15 April, after having lost as much as 15% year to date in the days immediately after the 2 April tariff announcement.
Over the past couple of weeks, the Trump administration shifted from an initial set of high and broad tariffs on most trade partners to a more moderate universal 10% tariff coupled with a significant focus on China, which currently faces a 145% tariff rate on most products.
Even after the latest tariff changes, we believe the chances of a U.S. recession remain elevated – close to a coin flip – and hinge on the ability of U.S. supply chains to pivot out of China to other sources of production fairly quickly, a process that won’t be seamless.
Latest developments on tariffs
In the days following the Trump administration’s 2 April announcement of broad universal and reciprocal tariffs, there have been several carve-outs for specific products and a 90-day delay in implementing reciprocal tariffs. The net result of these changes left U.S. tariffs more heavily focused on China, which currently faces a 145% tariff rate on most products. Elsewhere, the U.S. has a 10% universal tariff on all imported goods from other countries, with separate tariffs on Canada, Mexico, and a range of products, with more product-focused tariffs likely to come.
While there is no guarantee that the current tariff approach will last through or beyond the 90-day reprieve, some form of the current policy will likely remain in place. Amid the evolving details, the administration has been steadfast in its ultimate goals: opening up markets for U.S. exports, eliminating unfair trade practices in other countries, and reducing, even eliminating, reliance on Chinese production.
Decoupling the U.S. economy from China
Because tariffs have shifted from high and broad to more narrowly focused on China, we believe the potential for the U.S. economy to evade a near-term, tariff-driven recession hinges on a relatively seamless import substitution from China to other countries.
If maintained at current levels – or even if lowered somewhat – tariffs will likely drive a collapse in U.S. imports from China. Based on empirical estimates of the reaction of import volumes to changes in import prices – i.e., for every 1 percentage point increase in the average effective tariff rate, imports fall by 1 percentage point – a Chinese import tariff of over 100% should reduce U.S. imports from China to zero.
If all or some of these Chinese imports can be replaced by similar goods from other countries where the U.S. levies only the 10% universal tariff, then the near-term disruption should be more moderate, although still meaningful. We are skeptical this can occur without a period of disruption for several reasons:
- Shipping and logistical disruption at ports and points of entry is possible as supply chains readjust. The pandemic experience highlighted the fragility of global supply chains, and the recent surge in supplier deliveries alongside tariff announcements highlights companies’ concerns about new supply chain disruptions. The recent experience of the U.S. postal system’s inability to manage tariffs on small packages after the U.S. temporarily closed the de minimis exemption on imports from China is one example of the U.S.’s own administrative challenges in the face of such significant policy change.
- Chinese production on a subset of products is likely not easily substitutable. According to the U.S. Department of Commerce, over $100 billion of imports from China have an import share greater than 75%, a number that rises to over $200 billion when the threshold is lowered to 60%. Products that are highly reliant on Chinese imports include consumer goods such as video games, appliances, and computer peripherals such as keyboards. Even significant production increases in secondary source countries likely would not be enough to bridge the gap in the near term, which could leave U.S. consumers having to absorb the majority of the tariff increase.
- Even if other countries can absorb the extra demand, producing similar goods will likely come at higher costs. In fact, price differences between Chinese products and their close substitutes are likely higher than the 10% universal U.S. tariff on all other countries. According to census data, China has around a 30% price advantage to the average global producer across all goods imported into the U.S. In categories where China holds a majority share of imports, the price difference – if a similar product is being produced elsewhere – can be as high as 50%–75%. Even in categories with lower Chinese import concentration, the average price difference is 20%.
- The U.S. likely doesn’t have the additional domestic manufacturing capacity to absorb the lost Chinese production at any cost, due to the decades of erosion of the U.S. manufacturing base. The ability to absorb demand for domestic products would require a significant pivot for U.S. manufacturing. Over the past 20 years, U.S. manufacturing capacity has grown a total of 1.2%, according to the Federal Reserve, while over the same time frame U.S. real goods consumption has increased 78%, according to the Bureau of Labor Statistics.
What does all of this mean?
Because building new production capacity – whether in the U.S. or among other trade partners – takes time, the key question is whether current capacity outside of China can absorb the increased demand from U.S. importers. How quickly and at what price those shifts can occur will dictate much of the magnitude of supply chain disruptions and U.S. price increases.
If the shifts happen relatively seamlessly, the new trade flows could offset some of the impact from the U.S.’s now 10% universal import tariff. Mexico and Southeast Asian countries such as Vietnam could be relative winners, even with a 10% tariff. Domestic import substitution will likely be limited for some time given the state of U.S. manufacturing. And for a subset of products usually sourced from China, substitutes will likely be harder to find, risking supply chain disruption.
Taking a step back, the administration’s tariff actions are the most significant since the 1930 Smoot–Hawley Act. Overall, we expect U.S. real GDP growth will grind to a halt later this year, while inflation reaccelerates. Recession risks remain elevated. While greater investment could benefit the U.S. economy in the medium term, some near-term disruption appears inevitable.
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Disclosures
Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.
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