The S&P 500 index edged lower on Monday as losses by healthcare companies overshadowed gains in the technology sector. At the same time, investors waited anxiously for the upcoming result of Trump’s meeting with Chinese President Xi Jinping at the G20 summit this week.

The Nasdaq slipped but tariff-sensitive industrials, headed up by Boeing Co, led the blue-chip Dow Jones Industrial Average to a nominal advance.

Although the S&P 500 ended the session in the red, it remained within a hair’s breadth of its all-time closing high reached last Thursday as markets reacted to a dovish statement from the Federal Reserve.

Wall Street is hoping Trump and Xi will de-escalate the trade war that has been blamed for a global economic slowdown.

In the latest trade-related squabble, FedEx apologized for mistakenly returning a Huawei phone to its sender, after misrouting packages from the Chinese tech firm last month. The move provoked the ire of Chinese authorities and raised the prospect of FedEx being added to China’s “unreliable entities” list. FedEx’s shares were down 2.7%.

Caesars Entertainment rose 14.5% on news that rival Eldorado Resorts had agreed to buy the casino operator for $8.5 billion. Eldorado fell 10.6%.

United Technologies Corp advanced 1.1% after Cowen & Co upgraded it to “outperform” from “market perform.”

Celgene Corp fell 5.5% after Bristol-Myers Squibb announced that its $74 billion deal to buy the Celgene was expected to close at the end of 2019 or beginning 2020, later than expected. Bristol-Myers closed out the trading day down 7.4%.

Approximately 6.31 billion shares changed hands on the major domestic equity exchanges, as compared to the 7.05 billion share average over the past 20 trading days.

A Third Fed Factory Gauge Weakens Unexpectedly

A third Federal Reserve regional bank factory survey weakened in June, adding to signs of waning momentum in manufacturing amid heightened trade tension.

The Dallas Fed’s gauge of manufacturing in Texas slumped to a three-year low of minus 12.2 as more firms saw conditions worsen, according to a report on Monday that also indicated further deterioration in the six-month outlook. The main reading was well below the minus 2 median projection following minus 5.3 in May.

The fourth-straight monthly drop is the latest sign Trump’s trade war with China is weighing on the expansion and follows Fed officials last week downgrading their assessment of the economy while citing greater uncertainty about the outlook. 

The downbeat June reading on manufacturing follows other surveys showing deterioration. The New York Fed’s Empire State index fell by a record, the Philadelphia Fed gauge dropped to a four-month low and the Institute for Supply Management’s national measure decreased in May to the lowest level since October 2016.

The composition of the Dallas report was mixed, with some gauges showing improvement. The measure of new orders rose slightly from a two-year low the prior month, while the measure of production also gained. Both remained at levels indicating expansion. The capital expenditures gauge slumped to a more than two-year low.

The index of future general business activity dropped to minus 2.7, the lowest since January 2016, as more firms said they expect worsened activity six months from now. Data were collected June 11–19 from 116 manufacturers in Texas.

Trump’s Tariffs Deaden and Divert Trade

In 2018, former Treasury Secretary Henry Paulson warned of an “economic iron curtain” dividing the U.S. and China. Bloomberg Economics’ analysis of U.S. import data shows that for many firms, the curtain has already fallen. Some have managed to find a path around it. Most have not, with a deadening impact on Chinese, American, and global business:

Bloomberg Economics’ analysis of data on more than 10,000 U.S. import categories shows the trade war has struck a significant blow, with shipments of tariffed goods from China to the U.S. falling sharply.

Companies are realigning their supply chains. Taiwan, South Korea and Vietnam have all seen sales to the U.S. rise in the categories where China faces tariffs. Even with those efforts, the gap left by shrinking Chinese exports is impossible to fill. That’s a reflection of the complexity of modern manufacturing, and China’s outsize role in global supply chains, making “Made in China” tough to replace.

The break in supply of crucial inputs is imposing significant costs on U.S. manufacturers — a problem that will be amplified if Trump follows through on his threat of tariffs on another $300 billion worth of goods.

U.S. tariffs have dealt a crippling blow to key categories of Chinese exports. For product categories that saw tariffs imposed from July to September 2018, the value of U.S. imports from China were down 26% year on year in the first quarter of 2019. 

This was driven by a drop-in volume, rather than an attempt by Chinese firms to maintain competitiveness by lowering prices. This reflects a difficult reality for Chinese exporters — profit margins that are too narrow to accommodate a big tariff increase without sliding into the red. 

A look at the financial statements of close to 1,000 Chinese factories shows just 60 had profit margins above 25%. Even taking account a drop in the yuan against the dollar in the last year, few could adjust down prices to absorb the tariff increase.

Trump’s aim in introducing the tariffs — reduce the appeal of locating production in China. “From China’s standpoint,” he said in a recent TV appearance, “it’s not good, because all of these companies that are paying the tariff are moving to Vietnam and other places in Asia.”

There’s some evidence that supply chains are shifting: In the first quarter of 2019, in the product categories where China faces tariffs, Taiwan and South Korea saw sales to the U.S. rise 29.9% and 17.3% respectively from a year earlier — largely driven in both cases by exports of printed circuits. Some of the Taiwanese electronics components that were being assembled in China are now being put together at home.

In the same period, Vietnam saw sales of China-tariffed products to the U.S. rise 26.8%. The story here is a rapid ramping up of production of lower value-added goods like furniture, which are relatively simple to produce.

Imports of TVs from China (not subject to tariffs) have soared. Imports of TV parts (subject to tariffs) have plummeted. A similar trend is evident in imports of tariffed and non-tariffed categories of liquid crystal displays — evidence of tariff dodging by reclassification of products, or buyers looking for near-substitutes to keep costs down.

Dodges and diversions abound. The overwhelming impression, though, is that supply chains are struggling to adapt. In the tariffed categories, U.S. imports from other countries are up, but not by nearly enough to offset the drop in Chinese supply.

That’s not a huge surprise. Even relatively simple products like clothing must be produced to demanding specifications if they are to meet the needs of U.S. buyers. Workers need to be trained. Machines purchased. Supplies secured. Quality checked. 

None of that happens overnight. For some machinery and electronics, where production is complex and other components of the supply chain are in China, it will not happen without a considerable delay.

Modest gains for third countries in exports of the tariffed categories need to be considered in the wider context of the blow from the disruption and from weaker Chinese and U.S. demand. Total exports from Korea and Taiwan are down 9.4% and 4.8%, respectively, from a year earlier. Excluding China, overall U.S. imports fell following the introduction of tariffs.

The Trump administration hopes that tariffs will spur onshoring of U.S. manufacturing, reversing the trend of the last thirty years which saw production shifting overseas. That’s already happening in some cases — domestic steel production is up. 

Elsewhere though, a mix of demanding product specifications, network effects that make it difficult for individual firms to move away from the rest of the supply chain, and higher costs for U.S. labor, mean barriers are significant. A slowdown in U.S. industrial production suggests home factories can’t replace missing imports. Therefore, U.S. imports from China are disappearing the gap is being filled from other sources.

That’s also the theme emerging from business responses to the U.S. Trade Representative’s proposal for 25% tariffs on a further $300 billion in Chinese goods. Everyone from Christian publishers, to a port that needs Chinese cranes to unload cargo, to a valve producer that invested in developing their Chinese supplier, is making the case that Chinese inputs will be impossible to replace without prohibitive cost.

The U.S. economy is already suffering as China’s tariffs hit sales of agricultural products. Inability — in the short term — to fill the gap left by Chinese products means a second blow as U.S. manufacturing firms miss crucial inputs into the production process. As the economic iron curtain falls, it’s not just those on the Chinese side that are suffering.