The Long View – How likely is a trade war?
After a shaky February for markets, volatility continued in March as President Trump announced higher import tariffs for steel and aluminium.
This comes at a time when the post financial crisis global economic recovery is already seen to be long in the tooth.
Using tariffs to garner votes
Tariffs are important in keeping Trump’s Republican base happy.
Republican voters’ approval of free trade has declined in recent years, as they believe that it has led to a reduction in manufacturing employment and a lack of wage growth.
So far, Trump’s tariffs are focused on areas in which US special interests can benefit and he can gain political points.
However, he needs to take into consideration the disapproval from sectors that use these raw materials and must pay higher input costs as a result.
These sectors employ more workers than the sectors that gain from tariffs.
Trade war is unlikely
While Trump’s new tariffs have dominated the headlines in March, it is worth remembering that his campaign promises were much more aggressive, calling for broad, sweeping tariffs.
What we are seeing now is actually toned down for Trump. His protectionism is likely to target China and Mexico, the countries which account for a large part of the US trade deficit.
This is unlikely to be the beginning of a trade war.
The broader US business community has condemned the tariffs.
Many of those corporations that are against the tariffs will be reaping the benefits of Trump’s tax reform.
If they believe a trade war is coming, they may become cautious and not use those tax gains to increase investments.
Tariffs can destabilise market forecasts
The US steel and aluminium sectors will benefit in terms of higher profit margins.
However, there are many sectors that use steel and aluminium as raw materials, like the auto sector, aerospace, construction, and heavy equipment.
These US sectors will be hurt by higher input costs.
For example, in the auto sector, the demand for autos is elastic, and the automakers will suffer as they are not able to easily pass on the higher input costs to consumers.
The direct impact of these tariffs on GDP is likely very small.
However, the indirect effect could have a bigger negative impact on GDP and markets.
Users of steel and aluminium will be hit by lower profit margins, reducing profit growth forecasts and direct investments.
Rotation from stocks back into bonds?
For US stocks, these issues raise uncertainty and a return to higher volatility, which reduces risk appetite and lowers return expectations for the year.
Stock analysts can decrease their earnings estimates for those companies affected by higher input costs.
Analysts in all sectors may need to factor in the risk of a trade war that would put an end to synchronised global growth.
On the other hand, bonds would return to a safe haven status.
While tariffs increase inflation expectations, which are normally negative for bonds, a dramatic drop in risk sentiment and higher volatility could offset the inflation rise and lead to stronger demand for treasury bonds.
Which global markets to avoid
Emerging Markets are particularly exposed because global trade growth is such an important driver of EM economic activity.
A drop in world trade would derail the EM growth story.
Asia is a region mostly likely to be affected as its production is generally more downstream in the global value chain.
In contrast, Latin American commodity exporters that are not heavily dependent on the US market, and are higher on the value chain, should be less affected.
Thus far, Mexico and Canada are exempt from the newest tariffs, but they are in the midst of their own NAFTA renegotiations with the USA.
While the situation does not look bright for either, the NAFTA renegotiations are expected to continue into 2019 and are unlikely to have a big impact on markets this year.
Reactions from China and the EU are key
The biggest destabilising threat would come from a strong tit-for-tat retaliation from the likes of China and the EU.
For now, it is expected that these major trading partners are most likely to respond to Trump in a calm, coordinated manner, using strong language and the WTO for guidance.
Jobs and stocks take precedence over trade
The Republican Party needs a strong stock market in 2018.
Despite President Trump’s numerous failures in his first year in office, he has been able to boast about record highs in the stock market and continued jobs growth.
The November 2018 mid-term elections are crucial for Trump and the Republican Party to maintain a majority in the House of Representatives.
A trade war would hamper global growth, destabilise stock markets, and force some industries to hold off on investments and job creation.
If Trump sees his trade policies pushing stocks into a bear market, will he hold back on further tariffs to avoid a political defeat for his party?
If he doesn’t, the electoral winter of 2018 may well be a very frosty one for the Republican Party.
Paul Connolly
Paul Connolly has been a journalist for more than 20 years, as a reporter and editor for Argus Media, Reuters, The Times, Associated Newspapers and The Guardian. He has covered Islamic Finance for Reuters in the 1990s. Paul has since helped launch three newspapers, as well as reported from Tokyo, Los Angeles and Stockholm.
