Fears of trade wars rose further in the past week. The US government gave additional hints that in addition to imposing import tariffs, it would toughen its stance on Chinese investment in the US to protect intellectual property. Scrutiny on trading partners was also increased to ensure compliance with the sanctions on oil imports from Iran.
It is very hard to determine how a trade war that might be triggered by all this would end. The best way to think about it is to realize that all players are uncertain about the other players’ willingness to retaliate; I would add that the uncertainty level is particularly high in the case of US President Donald Trump, who is pretty much a non-rational player. Retaliation is one way to learn about this willingness, but it could escalate easily and substantially.
Trump’s latest round of threats should be seen as a power play to get the Chinese to the negotiating table and make more concessions. So far, Chinese retaliation remains proportionate. Its leaders clearly see a trade war as a lose-lose situation. Furthermore, it will take at least another two to three months to travel the road from the announcements of additional tariffs on USD 200 billion of Chinese imports or investment restrictions in US technology companies to their actual implementation. A lot can happen in that time in terms of new negotiations between the US and China.
The risk is that Trump’s one-dimensional world view gives him the impression that he has the upper hand because of the large bilateral trade deficit with China. He might overlook the fact that China also has other ways of retaliating if things really get out of hand, such as exchange-rate policy, non-tariff barriers and its large pool of FX reserves that are largely invested in US Treasuries.
Meanwhile, the impact on global growth is extremely difficult to quantify. There would be all kinds of non-linear effects driven by feedback loops involving business confidence and financial conditions. Academic analyses based on history and on models suggest that a trade war involving strategic interaction could lead to tariffs in the region of 30-60%. At the higher end of that range it could potentially set back trade as a share of global GDP to where it was 50 years ago. The impact on GDP would be much less, partially due to import substitution by domestic industries, but it would be very negative nonetheless.
One important difference from 50 years ago is that multinationals have invested heavily in the past 30 years, under the assumption that trade openness would increase or at least not decrease. A trade war could therefore leave a lot of corporate assets stranded. From an economic point of view, that would greatly reduce corporate profitability, defined as the rate of return on assets. This is clearly something that would also damage reported earnings and that poses a serious headwind for financial markets. Such a headwind might actually be an important factor in restraining the US government from imposing further trade restrictions. Trump often tends to measure his personal success by the evolution of the stock market, and a sharp decline in equity markets might be one of the few things that could actually make him change his mind on the topic of trade.
What will stop Trump, however, remains a hard question to answer. Next to market discipline, domestic political constraints or the realization that others can hurt him just as badly as or even more than he can hurt them might also play a role. On the domestic side, one might also expect the business lobby to convince the Republican party that a protectionist trade policy is bad for business. However, the Republican members of Congress have already delivered tax cuts that serve the corporate sector well. They might now be more worried about losing out to Trump supporters in the mid-term elections than they are about losing friends (or funding) on the business side. In that sense, the tax cut may have weakened domestic constraints for Trump a bit, because its effect counterbalances the effect of tariffs on corporate profits, provided the tariff effect remains muted.
In the end, it might well take a combination of retaliation by trading partners and a negative response from markets to make Trump moderate his stance. Or not. Or he might change his mind for reasons impossible to identify in advance, or perhaps even after the fact. The reality is that the future behaviour of the US administration is simply very hard to predict. At minimum this means that uncertainty around a potential trade war scenario remains very high and will continue to confuse investors for some time to come.
Certainly, there is no reason for panic yet, but the most important part of an investor’s job for the next couple of months could well be careful monitoring of the risk balance around global trade dynamics. Good luck to all with trading on trade over the summer!
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