Summary

• Trade tensions between the US and its major trading partners have continued to escalate in recent weeks, with the US recently moving to propose tariffs on an additional $200bn of imports from China.
• These measures are on top of the already-announced tariffs on $50bn of Chinese imports and the US tariffs on steel and aluminium imports.
• To date, the impact on global equities has been relatively muted, with investors instead appearing to place more weight on the strength of the global economy and robust corporate earnings growth.
• In June, Chinese equities did underperform global benchmarks but weaker Chinese economic data may also have impacted sentiment.
• As more measures are announced we are increasingly seeing individual markets, particularly commodities, being impacted.
• The possibility of a full trade war remains a significant risk for investors to consider and could trigger a rise in volatility across asset classes.

What has happened?

Since Trump’s inauguration as President of the United States, his stated economic and geopolitical policy has been “America first”.  While attempting to unravel Obamacare and introducing tax reform were the key economic policy initiatives in 2017, this year the focus has shifted to trade policy.

The first significant step was the March 1^st announcement of tariffs of 15% and 25% on all US imports of steel and aluminium. This was followed by initial tariffs on Chinese imports to the value of $3bn.  When China responded with tariffs of its own, two further sets of imports, to the value of $50bn and $200bn, were identified by the US for tariffs. More recently, the US and the EU have made some progress in negotiating towards free trade, however global trade risks remain as the US have indicated a preparedness to target all imports from China.

The key measures implemented to date have been:

• Mar 23^rd: US tariffs on approx. $48bn of steel & aluminium imports (impacting Canada, EU, Mexico, S. Korea & China)
• Apr 2^nd: Chinese tariffs on $2.4bn of US goods (fruits, nuts, steel)
• Jun 1^st: US decision to end aluminium & steel tariff exemptions for EU, Canada & Mexico
• Jun 22^nd: EU retaliatory tariffs on $3.4bn of US goods (mostly metals, agricultural products & consumer goods)
• Jul 1^st: Canada impose retaliatory tariffs on $12bn of US goods (metals, food and consumer goods)
• Jul 6^th: US impose tariffs on $34bn of Chinese imports (mostly industrial inputs)
• Jul 6^th: China impose tariffs on $34bn of US farm and energy imports (US soybean and crude oil were listed)

Further tariffs have been threatened and proposed in between the implementation of these tariffs. There are highlighted on the timeline displayed in Figure 1 (below).

Is there a historical precedent?

The risk of a trade war has not been a major consideration for investors in recent decades. Although there have been minor disputes, such as over bananas in 1999 and steel in 2002, these have generally been resolved quickly and have not escalated into protracted disputes.

The most significant episode in history when trade tensions had a meaningful impact on the global economy was in the 1930s when, amid the stress of the Great Depression, a number of countries engaged in tit-for-tat protectionist policies of tariff imposition and currency devaluation.

Back then the initial impetus for the trade war was the Smoot-Hawley tariffs imposed by the US in 1930. Trade tensions escalated in the ensuing years, particularly after the UK abandoned the gold standard and devalued Sterling. In response, other countries devalued their currencies, or introduced capital controls and tariffs as a way of stemming capital outflows. These tit-for-tat actions prompted a slump in global trade and escalated the economic downturn that was already underway after the crash in 1929.

Figure 1

Source: Abbey Capital, Peterson Institute for International Economics & Financial Times

The potential economic impact of the current trade tensions

The recent World Economic Outlook from the IMF identifies a possible escalation of trade tensions as the greatest near-term threat to global growth. From an economic perspective, rising tariffs have both direct and indirect impacts. The direct effects include rising prices for consumers in the tariff-imposing country and reduced export volumes for the country on which tariffs are imposed. Supply chains could also be impacted with profit margins for globally-integrated companies reduced to the extent that production inputs are subject to higher tariffs.

These direct impacts are observable in the market already, with soybean prices declining on the expectation that Chinese tariffs on US soybeans will reduce the demand for the crop. Equally, the shares of European car producers sold off sharply in late June as the US threatened tariffs on European cars.

Chart 1. Soybean contract price: 03 July 2017 to 17 July 2018

Source: Bloomberg

However, there are potential second order impacts which may be more difficult to assess. First, the uncertainty around trade policy may prompt companies to halt or delay investment plans. Second, a protracted trade dispute could impact sentiment in equity markets, which in turn could impact investment plans. Third, to the extent that some sectors are protected by tariffs, resources may get misallocated and productivity growth could be impeded. The IMF estimates that if current trade policies are realised global output could be 0.5% lower by 2020. Other economists argue that standard economic models find it very difficult to quantify the indirect effects, and the outcomes could be worse than this.

Possible market impact

Given the potential macroeconomic implications, it is possible to extrapolate the possible impacts on markets. A combination of reduced profit margins, higher inflation and lower economic growth would most likely be negative for equity indices. While to date this has been more apparent in Chinese than in developed market equity indices, an intensification of trade concerns remains a downside risk for global equities.

To the extent that growth may be impacted, trade has the potential to impact monetary policy and bond and interest rate futures. The recent minutes from the FOMC highlighted the downside risk to growth from adverse trade developments, although these are balanced at the moment by upside risks.  An intensification of trade disputes could prompt a slower pace of tightening from central banks and support bonds.

Individual commodities such as soybeans and cotton have already been impacted, and the price movements in these commodities are likely to continue to be impacted if trade issues remain to the fore. In the 1930s countries responded to the trade threat not only with tariffs, but also with competitive devaluation of currencies to protect domestic industries. The current trade issues also raise the possibility of more disruptive currency moves; it is notable that the Chinese renminbi weakened in late June as the trade tensions escalated.

Summary

Trade policy has emerged in 2018 as one of the primary drivers of markets and a significant risk to the global economy and risk assets going forward. While to date the impact has been felt most acutely in individual commodity markets, the risk of an escalation in trade tensions could have broader implications for markets as we progress through 2018.

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