US-China trade deal stuck on enforcement impasse

Trade negotiations between the US and China hit an impasse last week over American demands for a one-sided tariff mechanism, according to a Chinese government source familiar with the situation. President Trump announced in a surprise tweet Sunday that additional tariffs on Chinese exports to the US would go into effect last week. Global equity markets are expected to open sharply lower on Monday in response.

US Trade Representative Robert Lighthizer has insisted that some of the US tariffs on $250 billion of Chinese goods will remain in place while demanding that China rescind all of its retaliatory tariffs, according to several media reports last week. In addition, the US side has proposed an “enforcement mechanism” for future infractions that would allow the United States to impose punitive tariffs but forbid China from doing so.

China has refused to accept the American demands, a Chinese government official told Asia Times. “One for you and zero for me isn’t the basis for an agreement,” the official said. In the worst case, the official added, China would have to “shrug its shoulders” and walk away from the negotiations.

The US president tweeted:

“For 10 months, China has been paying Tariffs to the USA of 25% on 50 Billion Dollars of High Tech, and 10% on 200 Billion Dollars of other goods. These payments are partially responsible for our great economic results. The 10% will go up to 25% on Friday. $325 billion of additional goods sent to the US by China remain untaxed, but will be shortly, at a rate of 25%. The Tariffs paid to the USA have had little impact on product cost, mostly borne by China. The Trade Deal with China continues, but too slowly, as they attempt to renegotiate. No!”

President Trump’s reference to “great economic results” suggests that he is overestimating US economic strength, as I reported in an April 28 analysis. The US Commerce Department last month reported 1^st-quarter GDP growth at an annualized 3.2% rate, but the headline number was inflated by temporary factors including net exports, inventory buildup and a surge in state and local spending.

Excluding temporary items, GDP growth was only 1.3%. Investment in plant and equipment showed zero growth, and consumer spending contributed just 1.2% to GDP growth, the lowest in three years.

On Friday, the Labor Department reported that the US added 263,000 jobs in April, far above the consensus estimate. It also reported a drop in the unemployment rate, due to an unexpected shrinkage of the size of the US labor force. More Americans are working at establishments surveyed by the Labor Department, but they are working on average fewer hours per week. The total number of hours worked (the number of employed workers multiplied by average weekly hours) is actually falling.

Some closely-followed economic surveys, for example, the National Association of Purchasing Managers’ PMI (Purchasing Manager Index) have shown marked softening during the past several months. The PMI tells exactly the same story as the labor market, once hours worked are included in the calculation. The US economy is slowing.

The year-on-year change in total hours worked (weekly hours X payroll employment) has slowed from a 2.4% rate of increase in July 2018 to only 1.4% as of April. As the chart below indicates, the slowdown in total hours worked tracks the decline in the Purchasing Managers’ Index.

This is far from a recession warning, to be sure. But weakness in the US economy is due in part to lower investment in buildings and machines, and uncertainty over the status of global supply chains due to the US-China tariff war is a major cause of the investment dearth.

I continue to believe that US economic growth will come in at under 2% during 2019, far less than the Trump Administration expects and slightly below the lower band of the Federal Reserve’s estimate of 1.9%-2.2% growth.

That also explains why bond yields remain so low and the yield curve remains so flat in the face of big headline growth numbers. The bond market sees through the statistical illusion to the slowing of the underlying economy.

Trump’s threat of new tariffs will give markets a nasty shock on Monday. Investors do not know whether the president’s tariff surprise represents a last-minute negotiating tactic intended to hasten the conclusion of a trade deal or an unexpected escalation. But there is a considerable risk that Trump has vastly overestimated the strength of his position, and that a worsening of the tariff war will lead to more economic weakness and falling asset prices.