Market volatility ratcheted up again recently on growing fears about the prospects of a global trade war. Last week, U.S. stocks posted their worst week in two and a half years in part on the news of the Trump administration’s announcement of its intentions to levy tariffs on a variety of consumer and other goods from China. This commentary examines what’s been announced so far and offers a few key takeaways for investors to consider.
What’s taken place so far?
Thus far in 2018 the Trump administration has announced three separate rounds of trade-focused actions aimed at countering perceived “unfair” trade practices employed by foreign governments.
The first of such actions occurred in January when the administration announced multi-year tariffs on solar panels and washing machines.1 The second round of actions followed in early March when the administration made a surprise announcement that it intended to impose indefinitely a 25% tariff on steel imports and a 10% tariff on aluminum.2
Whereas the market reaction to the first round of announcements of new tariffs on solar panels and washing machines was muted, the second round of tariff announcements led to a spike in market turbulence as equity markets sold off amid fears that the newly announced tariffs presaged the further erection of trade barriers and an escalation toward a trade war. Following the initial sell off, however, markets subsequently regained the lost ground and then some, as investors’ collective fears of a trade war ebbed as the administration announced a growing list of countries to be exempted from the tariffs including major trading partners and allies such as Canada, Mexico, the European Union and others.3
Fears were reignited, however, last week on March 22, when the administration announced plans to impose tariffs of up to 25% on up to $60 billion of annual imports from China in an explicit effort to reduce the $375 billion bi-lateral trade deficit between the U.S. and China. In addition to the new tariffs, the president revealed that he had ordered the U.S. Treasury to come up with a plan to impose new restrictions on Chinese investment in a range of sectors in retaliation for China’s technology transfer and intellectual property practices.4 China responded relatively benignly shortly thereafter by proposing new levies on more than about $3 billion of American imports covering more than 100 different goods ranging from steel pipes to fresh fruit and wine as well as pork and recycled aluminum.5 Both the actions, while not as severe as those anticipated by some market observers nonetheless rattled investors worldwide and led to U.S. stocks posting their worst week in two and a half years during the week ended March 23 (the S&P 500 Index declined by 5.9% for the week).6
Three key takeaways for investors
1. Economists generally view tariffs to be a net detractor from economic growth.
Contemporary economists are taught early on that trade restrictions—and worse, trade wars—are damaging. Tariffs, which are simply a tax on imports, increase the costs of cross-border trade which in turn reduces global trade. Such a reduction in trade creates an inefficient (i.e., sub-optimal) allocation of resources by reducing the scope for the law of comparative advantage to work and for technology to flow easily across borders. A reduction in the gains otherwise accruing from free trade ultimately impairs the productivity of labor and capital alike and detracts from global prosperity.
Tariffs have historically been justified by governments imposing them on multiple grounds including but not limited to: (a) as a source of raising revenue for the government, (b) as protection for infant or otherwise strategic industries and (c) as retaliation/correction for market distortions caused by other governments’ trade practices.
Some analysts have optimistically suggested that the Trump administration may be using the recently announced tariffs predominantly as a negotiating tool in order to get other countries (e.g., China) to further open their markets to us exports and investment. Other observers, more pessimistically counter that the president and many in his administration have always leaned toward a nationalistic stance on trade and that the current policy announcements are in and of themselves not surprising and that they shouldn’t be interpreted as a means to any end other that limiting or otherwise raising the costs of imports.
2. The economic impact of an escalation to a full-scale trade war is estimated to be manageable; however, the risks are skewed markedly to the downside.
For a long time, global trade has been generally trended in the direction of becoming freer and less restrictive. According to a recent article from Vanguard, “U.S. tariffs have been falling since the 1930s and have been below 5% for more than four decades…According to the World Trade Organization’s latest report on tariffs, the current average U.S. tariff is 3.5%, the second-lowest in the G-20.”7 Separate research from the World Trade Organization states that as of 2013, the average tariff applied by WTO members was just 9%.8
Gavin Davies, the chairman and founding partner of Fulcrum Asset Management, wrote recently in the Financial Times, that there are relatively few published studies simulating the impact of a trade war with widespread retaliation.9 Davies does, however, cite two separate studies—one published by the OECD and the other by Goldman Sachs—that he was able to find on the subject and concludes that fairly severely defined “trade war” in which all countries including the U.S. impose an additional 10% average tariff on all imported goods would administer a noticeable, albeit, seemingly manageable negative shock to global GDP growth. According the Davies, “the available (though not very convincing) evidence suggests that the global output losses from a trade war might reach 1-3 percentage points over several years, with a left tail that could be much worse.” Davies notes that such a negative shock to growth may be “a bit less than investors currently fear.”
Davies’ conclusion from the research citied is further supported by research from Vanguard in the aforementioned article which noted that “we estimated that this trade-war environment could reduce GDP by 1.7 percentage points and increase inflation by 0.4 percentage points annually.”
While Davies and Vanguard both note that the estimated overall hit to economic growth may seem manageable at first glance, they both point out that the downside risk could ultimately be worse than estimated due to a variety of factors including: (a) the substantial growth in global production chains means that breakdowns in trade could have an even more negative impact than first estimated due to cascading effects, (b) uncertainty about future tariffs could sap business confidence and reduce capital investment and (c) economic and political partnerships across countries could be impaired leading for further unforeseen negative consequences.
3. Investors should expect more asset price volatility as the markets digest new developments.
We view the probability of an escalation of the current rhetoric and policy to a full-scale trade war as relatively low due to a host of factors, most notably the general recognition among economists of various political persuasions that trade wars are universally bad and thus should be avoided. Nevertheless, we anticipate that future rhetoric and policy announcements will continue to be a source of volatility in markets as investors constantly incorporate new information and adjust their expectations about the likelihood of certain events occurring and their impact on financial assets.
Investors should take some solace in the recognition that economic and corporate fundamentals remain solid both at home in the U.S. as well as abroad. In addition, the Trump administration’s other policy actions on taxes (i.e., lower) and regulation (i.e., less) should continue to provide a tailwind to growth and corporate profitability at least in the near term. That said, given the potential downside risks involved in a deterioration in trade policy, we believe it’s prudent to monitor the developments closely.
1 “U.S. Imposes New Tariffs, Ramping Up ‘America First’ Trade Policy” Wall Street Journal. January 22, 2018.
2 “Trump to Impose Steep Aluminum and Steel Tariffs” Wall Street Journal. March 1, 2018.
3 “Trump Will Exempt EU, Other Allies From Steel and Aluminum Tariffs, US Trade Representative Says” CNBC. March 22, 2018.
4 “Donald Trump to Impose 25% Tariffs on $60bn of Chinese Imports” Financial Times. March 22, 2018.
5 “China Prepares Retaliatory Tariffs on US Imports” Financial Times. March 23, 2018.
6 “US stocks Suffer Worst Week in More Than Two Years” Financial Times. March 23, 2018.
7 “How Likely is a Global Trade War?” Vanguard. March 23, 2018.
8 “Trade and Tariffs: Trade Grows as Tariffs Decline” World Trade Organization.
9 “Trade Wars and the Prisoners’ Dilemma” Financial Times. March 25, 2018.
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