By Erik Norland, Senior Economist, CME Group

Highlights

• U.S.-China trade war could trim company profit margins in both nations
• Companies likely to pass on a portion of the higher costs to consumers
• Tariff impact on U.S. companies will be modest relative to corporate profits
• Weaker renminbi to partially offset negative impact on China’s economy

The level of U.S. tariffs on Chinese products and the number of goods they cover are constantly changing as the trade dispute between the world’s two largest economies escalate. To help investors evaluate the possible macroeconomic impact from the trade war, we put together a back-of-the-envelope economic analysis (Figure 1). Like any similar approach, it contains many simplifying assumptions and will not fully capture the complex reality of the dispute’s economic impact, but it will provide a framework for evaluating the effects on inflation, corporate profits, Federal revenues and Chinese GDP. As is the case with monetary and fiscal policies and currency movements etc., there are many second and third order possibilities to consider. Let’s break down the assumptions into their four categories:

U.S. Inflation: Import tariffs are essentially a sales tax and raise costs for consumers. The question is by how much? The simplest assumption is that consumers will bear 100% of the cost of the increased tariffs. For example, if the U.S. has a $20 trillion GDP and the government imposes a 10% tariff on $200 billion worth of imported goods, then U.S. consumers would see the average price level rise by 0.1% (10% X $200 billion / $20 trillion). The good news for consumers is that this calculation ignores the notion that some of the impact on consumer prices will likely be absorbed in the form of lower corporate profits – both in the United States and China. Additionally, the trade war negatively impacts China’s renminbi (RMB) and through it many emerging market currencies (Figure 2). Weaker emerging market currencies translate to lower import costs for U.S. consumers, offsetting a portion of the tariff impact. As such, we assume that roughly half of the consumer impact from higher tariffs will be absorbed elsewhere.

Corporate profits: If 100% of the impact of the trade dispute came out of corporate profits, a 10% tariff on $200 billion worth of goods would lower U.S. corporate profits by the equivalent of 0.05% of GDP. Since corporate after-tax profits are around 9% of GDP, that would mean that corporate profits would fall by around 0.5% or 0.6%. If the tariff goes to 25%, then U.S. corporate profits could fall by 1.25-1.5%, if the impacts of the trade dispute were full absorbed by lower profit margins. However, some of the costs are likely to be passed along to consumers. Moreover, some of the negative impact of the trade war will also be buffered by Chinese enterprises, which may offset some of the tariff impact by lowering their own profits margins. Finally, if the value of the Chinese currency falls (and it already has) and drags other currencies lower, this could also hurt U.S. corporate profits. As such, we estimate that about half of the cost of the tariffs will in one way or another be borne by U.S. corporations by way of lower profit margins.

Compared to the size of corporate profits, the tariff impact is relatively modest, which may explain why U.S. equities aren’t too troubled by it. It may also explain why the tech heavy NASDAQ and the small cap Russell 2000 have outperformed the multinationals-dominated Dow Jones Industrials Average and the S&P 500®. Many of the big U.S. tech firms that dominate the NASDAQ 100 (Google, Amazon, etc.) have limited access to Chinese markets and are relatively unaffected by China’s retaliatory measures. Likewise, many U.S. small caps focus on the domestic market and their supply lines are not likely to be negatively impacted like those of the bigger firms that dominate the Dow and S&P.

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