Tariffs and trade wars

Escalation of trade wars brings more noise and uncertainty regarding the economic and financial-market outlook. Filtering out the noise is necessary.
May 2019
  • Escalation of trade wars brings more noise and uncertainty regarding the economic and financial-market outlook. While uncertainty is not ideal for investors, filtering out the noise is necessary to navigate this episode of market turmoil.
  • Our positioning and recent re-allocations reflect our constructive, but cautious, stance on risk assets. We think investors have tended to overreact to headlines and fear of Trump policies. The December fears over an imminent U.S. recession along with some yield-curve inversions were clearly overblown as the resilience of the U.S. economy was underestimated.
  • Ultimately, we believe stock markets, together with the economic data flow, are the key enforcing mechanism for Presidents Trump and Xi to reach a deal.
  • A deal is possible for the upcoming G-20 meeting in June. At the very least, we expect “constructive” progress on trade talks rather than further escalation, which should be enough to support risk appetite.


Tariff Man strikes back

President Trump’s Twitter feed was busy last week as he increased the pressure on China to make concessions and reach a trade deal. U.S. tariffs on Chinese imports were raised from 10% to 25%, impacting $200bn worth of imported goods. Unsurprisingly, China retaliated with higher tariffs on U.S. imports with scope for other measures. Investors dislike uncertainty and growth headwinds, so it’s not surprising that global stock markets took a steep nose dive. In 2018, China imported $120bn worth of goods from the U.S. but exported $540bn worth.

A wide chasm remains as the U.S. is demanding that China alter its commerce laws and China is refusing to do so. Earlier reports suggested China was open to such structural changes but recent backtracking has caused this fight to flare up once more.


A chronology of the Tariff Man

Shortly after taking office, President Trump began his trade-war journey by warning trading partners that bilateral flows would have to be recalibrated more favorably to the U.S., including intellectual property clauses. Even for partners like Canada, which has fairly symmetric trade flows with the U.S., that meant significant uncertainty as we saw with the aluminum and steel tariffs after agreeing to trade concessions with the U.S. Washing machines and solar panels were the first categories of goods hit by Trump tariffs in January 2018, but momentum accelerated with tariffs on Chinese imports that came last July.


The “Art of Deal” and the 2020 elections

Trump may be shifting from the view that a trade deal with China would help him politically by looking “tough on China,” in contrast to Democratic presidential candidates who tend to favor a less confrontational approach on trade. Ultimately, we think the stock market and the data flow may be the enforcement mechanisms for both the U.S. and China to reach a deal soon this summer. But for investors, the sooner, the better.

Although being tough on China resonates with a significant proportion of the U.S. electorate, potential headwinds to growth from trade wars clearly contradicts President Trump’s re-election campaign on a strong economy. These policies are at odds with each other.


Did recent strong U.S. growth and low inflation embolden the Tariff Man?

Possibly. The consensus view last year vis-à-vis escalating trade tensions and tariffs was that it could trigger inflation and cause slower economic growth, while a growing number of analysts were calling for an imminent recession. Not only did the U.S. avoid a spike in inflation thus far, economic growth has been surprisingly strong in the U.S. despite headwinds from higher interest rates from the Federal Reserve (Fed) last year. It’s easy to imagine Trump in the Oval office telling his economic advisors that all those fears of the negative impact of trade tensions were overblown, which would explain the timing of his latest moves on China.


Is global growth at risk?

The magnitude of the negative economic impact will largely depend on sentiment. While trade flows are highly asymmetric between the U.S. and China, stock markets may struggle more if the recent rounds of tariffs impact business and consumer confidence by delaying investment and spending decisions until we have more certainty on the policy outlook. More importantly, given the size of the U.S. economy, at +$20 trillion, the direct impact from tariffs is small as U.S.-China trade flows represent a only small portion of economic activity.

Tariffs and trade wars - Trade exposed to tariffs and retaliatory tariffs

BMO Capital Markets estimates that a full blown trade war—the worst case scenario—could shave 1% of U.S. GDP and up to 0.8% for Canadian GDP, whereas China could suffer a much larger 1.7% drag on economic activity. For that reason, we think China will eventually come to terms with the U.S., though the U.S. will also have to accept a less ambitious reshaping of trade flows.

Given the strong economic fundamentals in the U.S., we don’t see a recession in the next 12 months, but it won’t be as easy for U.S. growth to stay above 2% if sentiment deteriorates because of trade wars. Our immediate concern for 2019 is not the bite of the tariffs but rather business confidence declines, crimping investment. Meanwhile we would expect a rapid and measured response by China to maintain growth near their target of +6% growth.


Fed put is alive

In sharp contrast to last year when Fed Chair Powell sounded dedicated to policy normalization while equities were selling off, after some flip-flop, it’s now clear the Fed will be a lot more pragmatic and market friendly about its future policy. Investors have gone back to expecting the Fed to cut rates this year, which should help limit downside risks for equity markets. But if the U.S. and China manage to reach a trade deal this summer, which is our base case, expectations for rate cuts should gradually unwind as growth remains solid enough. However, we would expect a quick response from the Fed if growth was to suddenly slow. Certainly interest-rate markets could aggressively re-price for imminent cuts if growth stalled, but we’re far from that now. Current market pricing for the Fed has a cut priced-in by year end, with another one in 2020, which should help calm equity investors if the Fed articulated the cut as an insurance policy.


What have we learned on Trump since his election?

Clearly, investors were too optimistic thinking that Trump could be more about threats than actions. After making good on tax cuts and regulatory rollbacks that businesses wanted, he turned to a part of his economic agenda that many feared: tariffs. He is doing what he promised on trade and re-writing the rules of global trading. This policy could mean more trade-war headlines are likely, especially towards key allies, namely Europe and Japan.


“Too many German cars”

The Tariff Man may be prepared to extend his tariff-raising powers to motor vehicles given his momentum on China. The E.U. and Japan are the main targets and trade negotiations with the U.S. are heating up. Although the global impact on growth would be modest, tariffs on cars would severely impact Germany and Japan. Like Canada and Mexico, we think Europe and Japan will make concessions to reach a deal, most likely on agriculture products or energy. What might reduce the odds of tariffs on European car is that since 2013, BMW is the number one automotive exporter by value.


What if China sells U.S. Treasuries?

A recurring threat we hear is that China, which was the number one foreign creditor as of December 2018, could reduce its holdings of U.S. Treasuries ($1.123 trillion as of December 2018, or about 5% of the U.S. national debt). While China could sell U.S. assets at the margin, we don’t think it makes sense for China to explore that nuclear option. Finally, one way China can mitigate the impact of tariffs on its exports is through a weaker currency, but selling U.S. Treasuries would actually strengthen the Yuan.


Soybeans as a proxy for U.S.-China relationship

Highly emblematic bourbon and Harley-Davidson motorcycles got a lot of media coverage when Europe imposed retaliation tariffs last year, but soybean is probably a far more significant product, which is under tariffs by China. Since the Trump election, U.S. soybean prices have declined more than 30%, with most of the pain coming in this year. Given that soybean farmers are predominantly in key Republican states, we believe they are an additional motivation for Presidents Trump and Xi to compromise with each other. We doubt Trump’s plan for a humanitarian food aid program will solve the lack of demand for U.S. agricultural products and the hardship faced by U.S. grain farmers.


Overall, we believe our portfolios are well positioned to navigate this uncertain environment with a modest positive stance on risk. Equity market performance this year has demonstrated that investors tend to overreact to headlines and noise. Long-term investors should remain disciplined and invested when the economic backdrops remains broadly supportive, though not ideal as some uncertainty persists.

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