Stocks fell sharply on Friday as the trade war escalated.

At the start of the trading session, all eyes were on Jackson Hole, Wyoming awaiting a speech from Federal Reserve Chairman Jerome Powell that might give guidance to the future path of interest rates. Market reaction to his speech, which continued to suggest that the Fed would react to future changes in the economy were slightly positive. But at 11am, President Trump tweeted that he was ordering American businesses to make or accelerate plans to exit China. Stocks immediately fell by close to 3%. The tweet was in response to China’s earlier announcement that it was instituting another round of tariffs in response to American tariffs scheduled to begin on September 1. After the market closed, Mr. Trump followed his earlier tweet with an announcement of even higher tariffs on Chinese imports. Markets reacted even more negatively. When futures opened overnight, futures were down close to another percent. Then this morning, Mr. Trump said his trade negotiators had received two phone calls overnight seeking to renew trade talks. Futures reversed and rose by more than 1% before settling down. 

Mr. Trump, as we all know, looks to the stock market as his barometer. After Friday’s fall and with futures pointing lower again this morning, some comforting news, any comforting news, would serve to settle markets. From China’s perspective, the pace at which the rhetoric ratcheted up over the past few days was also disconcerting. Whatever China hopes to achieve, it does not want to see any acceleration in the pace at which American companies move supply chains out of the country. 

We study history in school because we are supposed to learn from the past. Since the end of World War II, the United States has engaged in four major wars in Korea, Vietnam, Iraq and Afghanistan. In each case, we were the ultimate protagonist. In each case, we had significant military superiority. In each case, the enemy suffered far greater human loss of life, and greater overall damage. Yet, we didn’t win any of the wars. While we hit the enemies with our best shots, they never surrendered. They were hurt but not intimidated enough to back away and give in to our demands that they recreate themselves into a Western style democracy. Indeed, during each successive war, the enemy learned from previous ones that if they persisted long enough, America would grow tired of war and leave. 

In each, the American goal was to force change. Whether it was to defeat communism and prevent its spread, or change political structure, we failed. One could point to the economic and political emergence of South Korea as a qualified success but Korea remains a split nation. North Korea remains both isolated and, now, a nuclear threat. 

Which brings us to our fifth war, the tariff war with China. While this isn’t a military confrontation, it bears resemblance to the previous ones. Again, we are trying to force change using our greater power. We are economically stronger than China. Their economy is more dependent on trade with the U.S. than we are with Chinese trade. To date, the trade war can better be described as a skirmish. That is how all the other four wars started. All, however, ultimately escalated far beyond our original intent. Friday’s news saw clear escalation; this morning’s comments are at least an attempt to pull that back a bit. 

History from our military battles creates a framework China may follow in the tariff war. In simple terms, it appears to be willing to take the necessary short term pain knowing that if the American economy weakens as the battle escalates, eventually the American public will pressure its government to back away from at least some of its key demands. Thus, while President Trump is correct that China will suffer more economic damage than we will if the battle escalates, it is problematic whether more pain will cause the Chinese to capitulate and change practices. History doesn’t always repeat itself exactly but basic patterns often reemerge. 

There is more commonality among China, Korea, Vietnam, Iraq, and Afghanistan. Each has been around for thousands of years. Their ways of life, their customs, have been in place for thousands of years. We may not like how other countries behave but if they have been acting in similar manners for centuries. Getting them to make huge structural change in their DNA via tariffs is a high barrier. 

Some argue, that the Chinese strategy is to wait out the 2020 election and hope Trump loses. That’s certainly a possible tactic. But, perhaps, China never intends to change at its core, at least until it has enough intellectual property to protect and reaches what it perceives to be a level playing field. 

The key word in the tariff war isn’t “pain”; it’s intimidation. If we cannot intimidate China or others to give in to our demands, then we won’t achieve our fundamental goals to change the way China does business. Our economic growth rate has fallen about a full percentage point over the past year largely due to the imposition of tariffs. The impact has spilled over to the rest of the world which has also slowed by a similar amount. Since China and the U.S. account for almost 50% of world growth themselves, it is logical that if the two of us sneeze, the rest of the world will catch our cold. That reduction in growth is before the latest escalation by both China and the U.S. set to begin in about a week. Will news of an overnight phone call set the stage for a rollback of new tariffs scheduled to start this weekend? We will learn more about that as this week progresses. 

There are no signs, absolutely none, to date that suggest China is about to change how it engages in international trade. No one questions the goals of reducing the theft of intellectual property, reducing the barriers for foreign countries to do business in China, or eliminating forced technology transfers. Those have been Chinese rules of engagement to date. No one likes them but, so far, businesses have learned to live with them as entrees to doing business with the world’s second largest economy. 

That doesn’t mean there shouldn’t be changes. The U.S. and its allies should seek changes at the World Trade Organization (WTO) to take away developing market status from China. As the second largest economy in the world, China hardly deserves advantages afforded developing nations. Similarly, when China dumps steel on world markets below cost, tariffs should be imposed. And they should be imposed worldwide. When South Korea dumped washing machines to the U.S. we petitioned and got relief. That is the way world order is designed to work. Trump has decided that the WTO is too slow and ineffective and, therefore, has chosen a unilateral approach. Time will tell whether that was the best tactic or not. 

Military wars have not hurt the stock market over the last 75 years. But an escalating economic war will. How much depends on the extent of the war. There is still time to suspend the September 1 and December 15 tariffs. There is an election in 2020 and clearly a recession created by as escalating tariff war won’t help Trump’s chances for reelection. History suggests that China is not likely to be intimidated into making the major structural changes the President wants between now and next November. They might buy more soybeans or agree to further talks. But the odds of serious change are low and they don’t necessarily rise as the tariffs get increased. 

If we don’t have long memories, the Chinese do. Just one generation ago, they were living in Mao suits. A stiff recession might be painful but if that is what is required to stay the course, keep to its economic 5-year plan, and continue to grow into a dominant world power, they will endure it. If the war escalates to the point where layoffs begin to happen in the U.S. and employment growth goes south, consumer confidence will fall and the recovery of the last 10 years will be over. Americans won’t be willing to accept that pain for very long. 

Bullies succeed as long as they can intimidate. Once, intimidation fails, a bully is neutered. Four wars have resulted in America retreating because (1) we couldn’t intimidate the enemy, and (2) we could only endure so much pain ourselves. This war most likely won’t end any differently. Once we conclude that China won’t agree to alter its DNA, and we tire of the impact of the trade wars upon us, a new approach, other than heavy handed tariffs may yield better results. 

In the interim, the past several days serve as a guide to what we should expect. Tweets and Chinese communiques are going to jerk markets violently in both directions. Ultimately, the course of corporate profits and interest rates will be the final arbiters of stock prices. To the extent, this trade war adds costs and uncertainty, both stocks and interest rates will fall. The odds of recession increase. Corporations will continue to hold back on capital investments impacted by the trade uncertainties. 

Given that Mr. Trump looks to the stock market as his barometer of success, we should note that since Inauguration Day 2017, the stock market is up a bit less than 20%. That is a below average performance for a post-World War II President. Since the start of 2018, a span of almost 20 months, the market is essentially unchanged. The tariff wars have counteracted the benefits of tax cuts and deregulation. More tariffs clearly won’t help in the short run. Forcing structural change is a long term fight and may not be a winnable one. Time will tell. Winning battles isn’t the same as winning a war. China will agree to some changes to protect its core DNA. If those changes are sufficient for Trump to declare a victory, a truce of some sort will follow and life will go on. The hawks within the White House trade team want nothing less than complete structural change. At the moment, they still have Trump’s ear. But as elections get closer, as economic growth slows further, and if China shows no willingness to alter is core DNA, we will see how much pain the White House is willing to endure. 

Today, James Harden is 30. Macaulay Culkin is 39. Melissa McCarthy turns 49. 

James M. Meyer, CFA 610-260-2220 

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