Key take aways:
U.S./China row now focuses on tech as well as tariffs.
Tariffs on Mexican imports will have an immediate hit on supply chains.
Macro data will lag equity index movements.
As a more restrictive attitude towards global trade approaches, a rework of its trade agreements and treaties by the U.S. government has become more obvious. Over the past few years, we have generated background material on the matter in order to give a broader understanding on global trade developments and their importance for real economies and asset classes. For this purpose, we published a CIO Insights Reflections publication in March 2017, where we wrote about global trade developments and their history, milestones in international trade agreements, theoretical arguments for both free trade and protectionism, making the case for free trade. Another issue of our CIO Insights Reflections publication on the same theme followed in October 2018, which covered the U.S. government’s tougher stance on imposing tariffs, initially on imports of steel and aluminum from the EU, Canada, Mexico, and then on a broad range of goods imports from China. The global division of labour and international competitiveness in the production of certain goods usually tends to lead to trade imbalances. In the October 2018 edition, we focused on global current account imbalances because if imbalances grow into magnitudes that are not deemed tolerable then they may have serious domestic economic disadvantages, leading to political reactions in the form of likely protectionist measures. In the publication we concluded that “large and long-lasting imbalances are economically unhealthy and may cause negative, unintended economic side effects. A forward-looking economic policy should therefore take large imbalances into account and implement corrective policy measures. These include long-term structural reforms with longer-lasting changes and effects. Short-term successes are rather unlikely and as regards recent developments in the trade conflict between the U.S. and China, it may well be that the conflict escalates before it settles down.” As trade conflicts tend to be “no-win situations”, we expected all parties involved to be interested in finding a solution, being confident that further escalations in the trade disputes could be avoided.
Negotiations with China
These expectations unfortunately have not been fulfilled so far. To the contrary, the situation seems to have worsened significantly. The trade negotiations between U.S. and China had evolved in a positive way early in the year and there were hopes for a trade deal to be passed around or on the G20 meeting in Osaka at the end of June. However, these hopes were destroyed in mid-May, when U.S. President Trump signed an executive order to declare a national emergency regarding “threats against information and communication” systems. Although this order did not mention a specific country or company it was seen by some market participants as a step to ban Chinese tech firms from doing business in the U.S. This toughened stance on China has caused threats of retaliation. Chinese retaliatory measures are likely not to be announced in a prominent way, but will instead be implemented in a low-key manner. Meanwhile, China has increased their existing tariffs on USD 60 bn of U.S. goods. And as a tit-for-tat in the tech sector, they are threatening to restrict access to rare earth minerals necessary for high-tech devices, autos, clean energy, and defense. Things seem to have escalated to an extent that it may be increasingly difficult to find face-saving agreements for both parties.
Trade dispute on another front
While the end of the U.S.-China trade talks has put the conflict on a new level, President Trump has opened a new front by instituting a 5% tariff on imports from Mexico effective June 10. The rate is set to rise every month until it reaches 25% in October. The level is conditional on increased progress on the migration “crisis” from Mexican authorities. Mexico has stated it will not retaliate until there have been talks to the U.S. However, due to the interweaving of trade/tariff issues with migration and domestic policy issues, the complexity of negotiations will be complex. Progress is likely to be slow at best, and the impact of the announced tariffs on U.S. imports from Mexico will probably be severe. The U.S. imports approximately USD 30 bn of goods per month from Mexico, of which 30% are cars & car parts. Large parts of these imports are intra-company related, likely to disrupt large and complex supply chains. Therefore, the tariffs on trade with Mexico are likely to have more immediate and detrimental consequences for U.S. businesses and companies, than tariffs on imports from China (despite being similar in nominal size).
Impact on economy
Signs of solutions to the trade conflicts are not yet visible. Global trade growth has slowed to 3% in 2018 from 4.6% in 2017, and is expected to be 2.6% this year according to April forecasts from the World Trade Organization. The new export orders subcomponent of the Markit Global PMI index declined from 54.0 in January 2018 to 49.1 in February 2019. The recent escalation steps will continue to dampen global trade growth. There are significant risks that the trade conflicts could escalate further. However, a willingness to negotiate still seems there and the G20 summit would be an opportunity to restart initiatives to talk to each other. The longer the conflict situation prevails, the more detrimental it is likely to be. What is interesting to see is that equity markets seem to be taking a more balanced approach vs. detrimental effects from the trade conflict than last year, with index movements more similar. The fall-out in fundamental economic data is not yet visible to the same degree. Sentiment indicators are, however, poised to weaken and economic growth outlooks are revised downwards. Even the U.S. economy with its comparatively strong economic position is expected not to escape unscathed from the trade conflicts. Market participants expect that accommodative monetary policy measures will become necessary as market implied probabilities for a Fed rate cut already in September have increased to almost 90%.
Escalating trade conflicts are now spreading well beyond tariff issues. The interlinking of multiple issues also means that differences could become more difficult to resolve. This reinforces the case for sticking with our overarching theme: take profits and recalibrate.
Download this CIO Insights Memo as a pdf here.
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