I Think They’re Really Going To Do It: My Odds On The Trump Administration Targeting China In A Tariff War Went Up To 70% Today

Today the White House announced  that President Donald Trump has picked Larry Kudlow to replace Gary Cohn as director of the White House National Economic Council. Kudlow worked as an economic advisor to President Reagan where he was a dedicated believer in supply-side economic policies, and he is known as an advocate of expanding global trade.

I believe Kudlow’s appointment to the job of the administration’s top economic adviser just about assures that the President will announce a big package of tariffs (and maybe other measures) aimed at China within the next week or two. Such a package would certainly increase the chances of a trade war between the United States and China.

Why does Kudlow’s appointment lead me to up my odds on a China tariff war? After all, if he’s an advocate of expanding global trade wouldn’t that mean he’d push back against the economic nationalists in the Trump administration, such as Peter Navarro and Commerce Secretary Wilbur Ross?

Here’s my logic. We know President Trump is itching to announce a big package of trade measures aimed at China. In a meeting last week he rejected a proposed package aimed at $30 billion in Chinese goods–because it wasn’t big enough. Reports today say that the new proposal would target about $60 billion in China exports to the United States.

I’d assume that Kudlow knows this and that one of the first questions that the President or any member of his team interviewing Kudlow would put to him is “Would you support this action against China?”

From an interview that Kudlow gave to CNBC, where he has been a commentator and expert guest, we know, to my mind, exactly where he came down on the question. Kudlow told CNBC that he does believe in targeted responses to individual countries that, from a U.S. perspective, violate the trade rules. “China needs a comeuppance on trade. I believe that,” he said.

In other words this new appointee doesn’t have some objections to the proposed policy. He isn’t going to be a voice arguing against targeting China. He’s told the administration that he’s on board with aggressive actions that target China’s exports to the United States.

If the administration announces that rumored $60 billion package aimed at China, I’d expect to see another market sell off, like the one that greeted the announcement of 25% tariffs on imported steel and 10% on imported aluminum. The selling then was severe, for a day, and some stocks, such as Boeing (BA) haven’t recovered from the drop.

But that drop didn’t turn into a longer rout in the general market–largely because the initial announcement has been followed by negotiations that have walked back some of the tariffs (those against Canada, Mexico, and Australia, for example) and because, so far, none of our important trading partners has actually done anything to retaliate. The reaction of those trading partners has been limited to words–so far.

I’d say that the likelihood is that any announcement of a $60 billion or so package of trade measures targeted at China will begin in the same way–with a deep but relatively narrow sell off in what are seen as vulnerable stocks (Apple (AAPL), for example.

And then the trend in the market will depend on what the Trump administration says and on what China does.

If, after the announcement of the initial package of tariffs, the Trump administration “makes nice” with talk that sounds like it’s possible that the two countries will reach some kind of trade agreement relatively quickly and easily, then the selling will dissipate leaving little behind besides some bruised individual stocks and a residual nervousness. If, however, the Trump administration hauls out the rhetoric favored by China-bashers like Navarro, then the sell off will get more serious.

The trend after than will depend on the Chinese response. I can imagine a period in which China takes the high road and speaks and acts like it is the mature, rational, dependable trade partner and champion of global trade that the United States obviously isn’t. There’s solid self-interest that might make China take that route. It certainly isn’t beyond China’s leaders to play the long game, especially now that President Xi Jinping has seen the constitution amended so he doesn’t have have to step down as president until he wants to. Playing the long game would be a recognition that acting like the important global superpower goes a long way to being seen as the important global superpower.

But I can also imagine a contrary reaction. After all President Xi’s platform is based on the assertion of Chinese power in the world and a desire for the world to respect China–a kind of repeal of the humiliation of the nineteenth century occupation of China by Western Imperial powers. If your goal is respect in the world, it’s easy to understand why China might chose not to simply play the adult in the room in response to this gambit by the White House. If China decides to respond actively and forcefully, I think we’re looking at something worse than a few down days in the markets.

I don’t know how China will react. But I think the odds are pretty good that we’re about to find out.