Chief Investment Strategist and Chief Economist
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We explore two scenarios: settlement of key trade battles in the coming few months versus a prolonged escalation
The scope of the US administration’s trade battle is likely widening beyond our original assumptions, with the far larger auto sector now potentially in the cross-hairs. There are further concerns that the US may abandon multi-lateral channels for settling trade disputes altogether.
There are now two different outcomes that deserve analysis and comparison. A short, but severe trade skirmish is less of a concern to us than a long-lasting acceleration of tariff increases and retaliation.
A rapid settlement of trade issues would likely see trade-exposed equities across the world rebound sharply, given the severity of the impact upon global markets from trade war fears to date.
However, the rapid emergence of a second scenario, where a failure to settle the trade war could create strong headwinds for the aging US expansion and world growth, deserves equal consideration.
This “second scenario” would have clear negative implications for asset markets across the world, apart from for the highest quality fixed income, and for derivatives that rise in value when risk assets fall. Derivative strategies that benefit from rising volatility would gain value amid prolonged trade escalations.
While the durability of the global economic expansion is substantial and commonly under-rated, several negative channels of influence can begin to meaningfully undermine world confidence in the event of an escalating and prolonged trade conflict.
We believe many economists go too far in arguing that subsidies and discriminatory trade practices abroad have no impact at all on the US trade balance or US economic performance. Intellectual property protections are a substantive issue that might be addressed with multi-lateral support. In response to internal and external pressure, China has shown significant signs of moving to back international trade norms.
While reflecting many factors, the US trade deficit tends to be large when US unemployment is low, as it is now. The trade deficit tends to shrink when the US economy and employment are contracting. Holding savings rates and import propensities constant, trade deficits will rise in faster growing economies. Thus, a single-minded focus on the US trade deficit alone could easily undermine other positive factors and slow US economic growth.
The confidence of the US corporate sector – which has notably led other regions, and with an added late-cycle boost from tax cuts – is now beginning to weaken due to the impact of the earliest of the US trade actions. If, this was just the beginning, we would expect further deterioration in business capital spending intentions and eventually in both US and global consumer confidence if tariffs and retaliatory actions persist and escalate.
we believe an escalating trade war would likely cause greater damage to US businesses that operate globally than is currently discounted. These negatives also cannot be completely shielded from domestic-focused US firms and activity. Meanwhile, related US equities have far outperformed others since early March
News in relation to trade should be heavy in the near term. The current pace of new tariff threats and retaliation is unsustainable for the long-run without creating significant damage to the economic outlook.
This will eventually be realized by policymakers who will have important choices to make. With little guiding investors besides guesswork to ascertain coming trade developments, markets have been forced into a reactive mode.
For asset allocation, we and others are compelled not only to guess at the US administration and trading partners’ next steps, but also whether or not markets have under- or over-reacted. This is an unusual circumstance for trade policy to be so elevated relative to fundamental drivers of economic and market performance.
While our asset allocation is medium-term focused (12-18 months), the nature of current policy risks may suggest compressing the time frame to adjust to these focused issues near term. As noted, despite higher hedging costs as equity markets have weakened, we favor adding to risk hedges for the coming few months at the very least.
As our two scenarios above suggest, world financial markets have had a significant but not decisive move on trade fears. There is room for either a positive or negative further move depending on whether there are “quick deals” or this is “just the beginning”.