The decision by the Trump administration to impose tariffs on US imports of steel and aluminium has unsettled politicians, commentators, investors and financial markets as it could be the opening salvo in what turns out to be full-blown trade war.
Globalisation – the increasingly free movement of goods, services, labour and capital across borders – has been one of the defining features of recent decades and is widely believed to be a key driver of greater prosperity worldwide. Companies are better able to source labour, outsource production, locate suppliers and service customers across borders. A trade war threatens to throw this entire process into reverse, unwinding the hard won gains in efficiency that globalisation facilitated. Costs and prices will rise and productivity, profitability and prosperity will fall. The impact on financial markets will likely be equally profound.
There is a broad and deep consensus among almost all policymakers and government officials that trade wars are destructive. We need to provide a rational explanation for how a severe trade war scenario could crystallise if it is clear that it is a lose-lose proposition.
While economists see globalisation as a good thing, many people feel that they have not benefited from it. Workers do not always associate the improvement in their cost of living from cheap imported goods with globalisation, and some workers in developed economies have lost out as a consequence of globalisation.
The rise in social discontent has led to the threat of protectionism and is being reflected in political outcomes in the developed world. In other words, the globalisation pendulum has started to swing backwards (Fiugre 1). A significant reversal in the globalisation pendulum would be very damaging for global growth and for financial markets. But it is still unclear how far back the pendulum will swing as there are institutional hurdles – such as the US Congress, the World Trade Organization (WTO) and financial markets themselves – that may slow down, limit or even stop the current initiatives by the Trump Administration.
While President Trump may be the instigator-in-chief of the trade war and the policymaker most inclined to escalation, he has yet to follow through on his long-standing views on world trade. The opinion of the general public may have more traction than politicians or business leaders, as rising prices squeeze disposable incomes. However, higher prices are an inevitable by-product of Trump’s Make America Great Again agenda: if you want to wean the American consumer off cheap imports and encourage domestic production then the price of those imports must rise. Trump is probably most sensitive to financial markets and is probably most likely to be persuaded to de-escalate if his actions precipitate a sharp downturn in the stock market.
Realistically, policymakers elsewhere in the world may see little political advantage in standing up to Trump as it may increase the risk of escalation, whereas failure to retaliate might be punished by the electorate. Moreover, the forward-looking politician may realise that this could be a recurring situation – a ‘repeated game’ – and failure to retaliate against the US protectionist provocation now will be perceived as weakness by Trump and therefore invite further measures.
Figure 1 – Globalisation pendulum: reversal has started but should be limited by institutional speedbumps
Source: BNP Paribas Asset Management
China’s response to a trade war is harder to calibrate, depending on whether US policy is viewed as an indiscriminate move or specifically designed to target China. It is not implausible that China could attempt to defuse the situation by announcing a modest response. One advantage of the bilateral trade war scenario is that it is much easier for both parties to navigate towards a rational outcome. However, we are far from convinced that President Xi will view appeasement as a rational strategy in a repeated game with the US. The Chinese may instead conclude that a well-targeted response could force the US president to change course.
We consider two stylised tail risk trade war scenarios – the first a multilateral trade war between the US and the rest of the world, the second a bilateral affair between the US and China. We view both as low probability-high severity variants of a trade war with different narratives. While a temporary trade war could still influence economies and financial markets, a permanent pivot towards protectionism would prove far more economically destructive and have a far more profound impact on markets.
The key moment in a multilateral trade war would likely be the US being taken to the World Trade Organization (WTO). What matters here would be the immediate US response. Should Trump threaten to withdraw from the WTO, it would mark a sudden and significant escalation of the trade war that is likely to prompt a further coordinated response by the rest of the world.
The narrative of the bilateral trade war is likely somewhat different. The motivation for the protectionist measures lies partly in national security concerns in certain US policy circles and partly in a desire to coerce China into opening up its markets to US exports. The immediate catalyst for the confrontation is the US’s announcement of tariffs on USD 60 billion of Chinese exports to the United States. China has already responded by announcing tariffs on USD 3 billion worth of US imports and we suspect that these retaliatory measures between the world’s two largest economies could quickly spread beyond tariffs.
As far as the rest of the developed world is concerned, the bilateral trade war may look more appealing than the multilateral scenario. However, even as bystanders, Europe and Japan may still suffer in the cross-fire as asset and goods prices respond.
In both the multilateral and bilateral trade war scenarios, we envisage an escalation of tensions leading to further punitive measures as the lose-lose scenario plays out. But to repeat, we view severe manifestations of both scenarios as highly unlikely.
If either a multilateral or bilateral trade war were to develop, we would expect to see a marked correction in asset prices and a radically different set of returns on positions to the one we expect in our base case scenario. To understand whether, when and how to adjust portfolios, we need more information and to think hard about the road map for the scenarios.
The starting point is the stylised cost/benefit analysis of any potential hedge – that is, a static comparison of returns in a) the good state (no trade war) and b) the bad state (a trade war) – weighted by their perceived probabilities, which informs the required adjustment in portfolios. This static calculation makes a number of simplified assumptions about how a trade war evolves: that there is a sudden shift between the good and bad states, in which case there is little opportunity to take corrective action; or that markets adjust gradually as news evolves, in which case, investors can take corrective actions over time as more information arrives.
Decisions on portfolio construction therefore hinge on how we believe a severe trade war scenario would play out, and in particular whether asset prices will ‘travel in an elevator’ and make the full adjustment in one straight jump, or whether will they adjust in a series of steps (Figure 2).
Figure 2 – Probability of trade wars can evolve in different ways: elevator versus staircase
Source: BNP Paribas Asset Management
We believe the latter is the more realistic description of the way most tail scenarios play out. For example, there was more than a year between the outbreak of the Global Financial Crisis in summer 2007 and the denouement in autumn 2008, and there were several episodes of relief in the interim before the final collapse in asset prices. In the case of our trade war scenarios, we believe that the staircase scenario is particularly plausible, since a number of obvious escalation points suggest thermselves:
Thus, there is no immediate need to adjust portfolios to a fully defensive strategy if there is time to correct one’s course as events play out. Indeed, we do not expect these severe tail risk scenarios to play out. Instead, we think it more likely that a combination of a clear understanding of the benefits of trade, on one side, and institutional constraints and market discipline on the other will temper the desire for further escalation.
In considering our calibration of the tail scenarios, we model these trade wars as disruptive cost shocks, such that a combination of tariffs and quotas permanently raises the price of traded goods and services and leads to an inefficient reversal of the globalisation of production and supply chains that has occurred over recent decades. The end result is higher prices, lower productivity, and ultimately lower output.
The reversal of globalisation would naturally impact most heavily upon the countries that have been benefiting the most from it in recent decades – such as open emerging market (EM) economies, where corporates established their production plants to take advantage of low labour costs while applying their managerial know-how. Countries that have benefitted from globalisation typically have large exports/GDP ratios and these ratios have tended to rise since the 1980s. These are also the countries that are most exposed to reversals in globalisation.
Figure 3 – Countries whose exports/GDP ratios are the most exposed to reversals in globalisation (lhs) as well as the change in the ratio since 1980 (rhs)
Source: : World Bank, BNP Paribas Asset Management as of Dec 2016
Goods that are affected by trade tariffs/barriers will increase in price, leading to a raise in the cost of final output. Previous episodes of supply disruptions such as oil shocks did indeed lead to higher inflation (Figure 4). Demand could also weaken as the trade war breaks out, given the knock to consumer and business confidence and concomitant increase in uncertainty, and should then respond to the news on productivity and prices.
Figure 4 – Change in inflation after oïl shocks (pp)
Source: Bloomberg, BNP Paribas AM, as of March 2018
As always, the response of central banks – and how much they support or suppress demand and employment as the scenario unfolds – will prove critical in determining whether the shock is primarily manifested through higher prices or through weaker activity and employment. The central bank playbook is pretty clear on how policymakers should respond to adverse cost shocks from a trade war: accommodate the first-round effects but lean against the second-round effects by tightening policy.
Given our two scenarios for modelling the risk of an escalation of trade tensions, what are the likely consequences for asset prices? For our multi-lateral trade war scenario, we would expect broad equity indices to fall by around 15%-20%, with multinationals and technology companies hit the hardest. Initially, we would expect fixed-income markets to have a temporary bid from the flight to quality argument that would hold initially as market price in a risk-off world. Similarly, currencies such as the Japanese yen and Swiss franc would benefit from the initial shock, while EM currencies would depreciate. Once the initial shock has occurred, the response of fixed-income markets and currencies would depend on whether central banks accommodated the shock (which would prove inflationary) or offset the shock (which would prove disinflationary).
Crucial to the longer-term performance of equities under this scenario is the implicit view that the Trump administration is less prepared to pursue a global multi-lateral trade war for a protracted period than it would be to pursue a bilateral trade war with China. Under the bilateral scenario, the risk is that the US is prepared to accept significantly higher costs and take a longer-term view to achieving its objective. In this case, we would expect global equity markets to fall by between 30%-50%, with equity indices dominated by technology, multinationals and commodity producers suffering disproportionately.
While the two trade war scenarios are in our view still low risk at present, the prospect of increasing trade tensions as the political pendulum swings against greater trade liberalisation is likely to require higher risk premiums for a wide range of assets over time given the uncertainty associated with the direction of trade policymaking.
In terms of strategy, we are not altering our base case scenario of strong growth and contained inflation. But while we may believe that the probability of full-blown trade wars is still low we do expect further outbreaks of protectionist tension as the globalisation pendulum continues to oscillate, making the trading environment riskier. With higher uncertainty or ‘fatter tails’, market volatility should move higher and risky asset prices lower. If the trade war scenarios remain low probability it makes sense to hedge portfolios against them or to consider assets that do well in risk-off environments but that do not underperform if these risks fail to materialise.