Swiss Bank J. Safra Sarasin has published on June 20, 2018 an in-depth analysis of Trade Wars with a focus on investors, but we at TextileFuture think it gives a lot of facts and figures and food for thinking to our readers, this is why we publish the feature in its full length. The authors of the MacroStrategyFocus are Dr. Karsten Junius, CFA, Chief Economist, David Rees, Emerging Market Strategist, and Cédric Spahr, CFA, Equity Strategist of the bank
Trade wars to weigh on growth and financial markets
- We are becoming increasingly pessimistic about the current trade tensions and fear that there are few political mechanisms or incentives for the major trading partners to climb down from current confrontations.
- Politically, protectionism and a trade war might pay-off. Economically, however, there are no winners in a trade war. Higher tariffs will ultimately lead to higher inflation, policy rates, and lower productivity and economic growth. All of this is negative for economic and financial market sentiment.
- We doubt that China would retaliate by depreciating its currency or selling US- Treasuries. Instead, it could step up several non-tariff trade barriers.
- Emerging markets would come under further pressure in the event of an all-out trade war. Financial markets in large closed countries such as India would fare less badly than highly open countries in Asia, Central Europe and Mexico. Other countries to lose are those running large current account surpluses like Germany, Switzerland, Sweden, Japan, Taiwan or South Korea.
- Equities are likely to lose, while safe haven bonds as well as the Yen and the
Swiss Franc would benefit from higher risk aversion. Within equities, we would favour US small and mid-caps that benefit from stronger domestic demand.
What has happened: US imposed tariffs and China retaliated
Trade tensions escalate step by step and trigger a flight to safety in financial markets
Another unfriendly move: On Friday, June 15, 2018, President Trump announced the first concrete details of the tariffs that the US-administration will levy on imports from China. From July 6, 818 product lines, worth an estimated USD 34 billion, will face an additional tariff of 25 %. Tariffs on a further 284 product lines, with a value of around USD 16 billion, will undergo further review. The Chinese government responded immediately, stating that it too will impose 25 % tariffs on imports from the US worth USD 34 billion, and that it stands ready to target a further USD 16 billion of goods. In a further twist, President Trump announced on June 18, 2018 that he had instructed the US Trade Representative (USTR) to identify a further USD 200 billion worth of imports from China that could face an additional tariff of 10 %. What’s more, President Trump noted that if China were to respond in kind to such additional measures then the US-administration would target another USD 200 billion worth of imports from China.
As we previously discussed: The US-administration was always likely to unveil the first tranche of tariffs this month once it had completed its public consultation process. (See our Cross Asset Weekly, “Another week, another escalation of trade tensions”, April 6.) And if anything, the tariffs that will come into force next month were not quite as harsh as the 25 % tariffs on 1,333 worth USD 50 billion that was initially threatened. But, that did not prevent renewed fears of a trade war triggering yet more volatility in global financial markets. There was some flight to safety, which benefited government bonds, the Yen and the Swiss Franc. By contrast, equities took the brunt of the ensuing risk aversion. In developed markets, equities in trade-dependent countries such as Germany and Japan underperformed. And as we had previously argued would be the case, that pattern was largely mirrored in emerging markets (EMs) as stock markets in those countries that rely on export-driven economic growth tended to underperform those in relatively closed economies. (See our Cross Asset Weekly, “Which EMs are most at risk from a trade war?”, March 23.) Following on from this, in the event of an all-out global trade war, financial markets in highly open EMs such as South Korea, Taiwan, Mexico and CEE countries (such as Czech Republic, Hungary, Poland, Romania) would be likely to underperform those in relatively large, closed, EMs such as India.
The economic impact – There is no winner in a trade war
Populists in many countries build their support on nationalist and protectionist agendas
China could also retaliate by qualitative trade measures
Taken in isolation, the tariffs that will come into force next month will not derail either the US or Chinese economies, but will be negative for economic sentiment. USD 34 billion represents just 0.2 % and 0.3 % of US and China GDP respectively, and even then all of this output would not be lost. But tariffs on Chinese goods worth USD 250 billion, about 2 % of GDP, would be more problematic. And, despite past claims to the contrary by President Trump, there are no winners from trade wars. Domestic prices of imported goods will increase and add to the inflationary pressures that become increasingly visible in the US. To a certain degree that might increase domestic production of steel or other goods in the US. However, to the extent that imports are used in the production of US exports the US suffers from its own tariffs and it obviously suffers if its trading partners retaliate. The same is true for China, and other US-trading partners. As a result, global trade will decline and so will the efficiency of global production, hence, productivity and real wages. Beyond those direct welfare impacts we consider the indirect effects of the loss of confidence in the multilateral trading system, its rules and procedures, the trust in existing trade agreements as at least as damaging. In other words – globalisation is on a declining path which will translate into lower potential growth. As inflation is increasing with higher tariffs and lower productivity central bankers particularly in the US will have to increases policy rates in this cycle beyond what they would do otherwise. A boom-bust cycle is becoming even more likely than before. Needless to say, all of this is likely to further weigh on sentiment.
The rise of populism: We have long argued that in the current environment the US- administration is likely to escalate the trade tensions, and, that they can afford them economically in the short term. Boosted by the tax reductions, economic growth will remain strong in the US such that negative economic effects of lower exports will be overcompensated by stronger domestic demand. As US-growth will be stronger than that of its trading partners, its import demand will increase relative to its exports and so will its trade deficit. The US-administration will blame an increasing trade deficit on “unfair” trade agreements that harm the US rather than on its own fiscal policy. Protectionism might also resonate with Trump’s voter base ahead of the mid-term elections in November. Therefore, we regard it more likely that Trump will escalat these current trade policies into a global trade war as this might benefit him politically. As a result, NAFTA is likely to be cancelled as well.
What could stop a trade war?
Economic arguments won’t as has become clear at the recent G7-meeting. An increasing and aspiring super-power like China will always retaliate in order to save its face. The US-administration seems to base its strategy on the fact that the US exports less to China than China does to the US which in their view implies that China has less scope for retaliation. This is likely a mistake, as China will simply have incentives to retaliate with other means. Those could be qualitative rather than quantitative protectionist measures. The easiest would be enhanced customs procedures and administrative requirements that effectively delay US-exports to China. Beyond that there is wide scope for protectionist policies ranging from foreign direct in- vestments to intellectual property rights.
China will hesitate to sell US-treasuries as that would lead to a stronger Renminbi – however, the US-dollar’s status as reserve currency is eroding
The billion dollar question: Ultimately, there will be the question if China would retaliate to US-protectionism by selling US-treasuries. As shown in the graph below, China is the largest foreign holder of US-treasuries which basically implies that it is financing the US-trade deficit. Selling US-bonds would most likely lead to higher US-yields and a lower US-dollar. For a central bank that is holding foreign reserves for the long-run, this does not matter necessarily. However, a lower US-dollar and an appreciating renminbi would harm the Chinese export sector, which makes such measures unlikely so far. The broader question is whether the US-dollar can keep its status as global reserve currency and safe haven if it pursues an America First policy. By undermining trust in the multilateral system of institutions and rules that it has set up itself it is also undermining the safe-haven status of the US-dollar. Trading partners will wonder whether the US might use access to US-dollar liquidity as another means in a trade war and will diversify reserves accordingly in the medium-term. As a result, over time the US will lose its privilege to finance huge deficits at minimal costs.
We do not expect China to retaliate by artificially depreciating its currency
Forex-implications: The relatively sharp depreciation of the renminbi against the US-Dollar across Monday and Tuesday, which saw the currency weaken by a cumulative 1.3 %, raised concerns that the Chinese authorities would combat trade tariffs with devaluation. And on the face of it, an economic slowdown in China that already appeared to be in train before tariffs were announced is consistent with a weaker currency. But, there are reasons to think that a major devaluation is not imminent. First, significantly weakening the currency against the US-Dollar would risk further antagonising the US- administration given that President Trump repeatedly threatened to label China a currency manipulator, when on the campaign trail. Second, as we have argued in the past, the renminbi seems to be trading at around “fair value”. China’s current account sur- plus is small and stable, while the real exchange rate is below its trend level. (See our Cross Asset Weekly, “China: Reading the tea leaves”, March 9.) Third, following the 2015 debacle, the Chinese central bank (PBOC) has fought hard to convince the market that it will not allow a messy devaluation. Fourth, in line with this, it is notable that while a resurgent US-Dollar has driven some depreciation of the bilateral renminbi ex- change rate, China’s currency has been appreciating in trade-weighted terms. Of course, the 2015 “devaluation” came in response to rapid trade-weighted appreciation of the renminbi. But, the currency remains about 5 % below those trade-weighted levels that prompted the PBOC to change course.
US focus on trade is unlikely to vanish after the November mid-terms elections
An intensifying trade war between the US and China (and higher US-policy rates) are likely to augment risk aversion in coming months. This should support bonds (outside the US) versus equities as well as the Yen and the Swiss Franc. The stagnation of global central bank liquidity also buttresses the assumption that US equities should perform better in a tighter liquidity environment than other regions, as investors rotate toward more liquid markets which are deemed safer and more stable. At the margin, equity allocators will lean toward buying US equities, and probably cut back exposure to European, Japanese and EM equities slightly, out of fear those regions might suffer from additional US trade tariffs. Here are the most exposed countries and equity market sectors in the event of an intensification of trade frictions:
- Traditional export hubs in the Asia Pacific regions: Japan, South Korea, Tai- wan, Malaysia and Thailand.
- European exporters like Germany, and, to a lesser extent, France, Switzerland and Sweden. This could have knock-on effects for CEE equity markets, such as Hungary, Poland and Czech Republic, owing to close supply chain integration.
- Canada and Mexico are vulnerable to an end of NAFTA.
- Exporters of steel/aluminium, automobiles, capital goods, makers of textiles and apparel as well as producers of consumer staples (household goods)
- Financials are not primary targets of trade restrictions, yet if bond yields drift lower as a result of higher risk aversion, banks are likely to underperform slightly. We generally prefer US regional banks, which enjoy a robust domestic economy and the benefits of deregulation.
Sectors at risk: The US imports large quantities of manufactured goods, which include cars, industrial equipment, computers, telecom equipment, pharmaceuticals/medical equipment, and textiles. It is likely to target countries and sectors with large trade sur- pluses in those areas. Conversely, retaliatory measures would most likely target US agricultural products, selective industrial equipment and chemicals, where the US holds competitive advantages. We consider the risk of tariffs penalizing the information technology sector at this stage as less likely. We reiterate that a spiral of trade retaliation would hurt both the US and China, which share a complex and deeply intertwined sup- ply chain in the technology sector.
How to allocate the equity part in a multi-asset portfolio: We would favour buying “structural growth” when monetary policy gets tighter, which sustains the existing up- trend in technology and internet stocks. As short-term dollar strength might persist, investors are likely to keep buying US companies with a focus on domestic demand ‒ mainly small and mid-caps ‒ which are unlikely to be impacted by dollar strength. Such companies also have usually little exposure to exports. Some defensive sectors like utilities and health care might also offer a short-term safe-haven.
Medium term outlook: We increasingly share the view that Donald Trump and some of his counsellors like Commerce Secretary Wilbur Ross and Trade Representative Robert Lighthizer are serious in their intent to alter the existing trade system. Their focus goes far beyond the November 2018 mid-term elections. They observe with growing unease China’s strategic goal to achieve leading positions in high-end industries like robotics, computers, and aerospace by 2025, as described in its master plan “Made in China 2025”. The US is now acting to prevent a strategic leapfrogging by China. China indicated that it was willing to compromise on some key issues such as technology transfers, joint venture ownership, and intellectual property rights, but we wonder how long this holds if trade tensions escalate further. For financial markets, this implies that a repricing of trade risks ahead of the mid-terms elections in the US would not surprise us, which would trigger a period of higher equity volatility.
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