06 JUL

2018

Investor sentiment has been dragged down by “trade fatigue”, with the outlook for global GDP growth facing downside risks. We note that the recent decline in global risk assets (e.g. equities and high-yield bonds) is less pronounced than in the episodes of trade conflict that occurred earlier this year. While expecting the conflict to remain contained, we are aware that further escalation may still lie ahead after the implementation on July 6th of tariffs on USD34bn of Chinese goods and the Chinese retaliation. The Trump reaction function consists in putting maximum pressure on trade “partners”, but without derailing the US expansion, even in the domestic stock market.

First stimulate US growth, then put maximum pressure on World-ex US. The implementation of higher trade tariffs and the possibility of wider protectionist measures represent a key risk for global activity. It is not by accident that the Trump administration has set the stage for robust economic activity in the US by cutting taxes and pushing deregulation before intensifying its aggressive rhetoric on trade. As the US economy is accelerating towards 3% GDP growth this year, the risk of a cooling outlook due to trade restrictions will materialise only after strong momentum has been set. To some extent, the fiscal stimulus represents the Trump Put against negative spill-overs from trade policy.

Anatomy of a crisis. The current decline in global risk assets appears less pronounced than in the episodes of trade conflict that occurred earlier this year. We note, further, that real economic growth remains firm and that tail risks are contained. Among the drawdowns triggered by the aggressive trade rhetoric, the most significant stock market decline occurred in the aftermath of March 9th, when US President Trump signed new tariffs on steel and aluminium. In the two weeks that followed, US equities lost 7%, pulling global equities down by more than 5%. In the week after April 17th, when Chinese telecom equipment company ZTE became the target of the US authorities, US equities were down by close to 3%, whereas the US dollar surged by 2%, dragging Emerging market assets down. Eurozone equities were stable at that time, integrating the relative Euro weakness as a support.

Trade conflict rhetoric and actions intensify

What conclusion can be drawn from previous stress episodes? First, the current episode of trade tension is primarily hitting stock markets in Emerging markets, with China appearing to be the main target, followed by the US and then the Eurozone. Second, the recent drawdown appears to be less pronounced than in similar episodes that occurred earlier this year. Third, the previous drawdown ended once the US watered down its threats (i.e. offering temporary waivers) or offered to launch pre-negotiation talks. In the current episode, at least a short-term US-China trade conflict is underway, with the possibility of a longer-term trade war with no quick resolution.

What is the reaction function of the Trump administration? Obviously, the US President applies his “Art of the Deal” thinking to international relations. That’s why he prefers bilateral relationships to multilateral agreements. Declaring that the WTO is one of several international organizations the US should revisit in terms of US membership goes in the same direction. Further, it appears that the Trump administration makes no differentiation between “allies” (G7, NATO, NAFTA countries) and other countries. America first.

Another important feature of the Trump reaction function is the inclusion of the wealth effect of his American electorate. With the November 6th mid-term elections in mind, the Trump administration cannot afford a stock market crash. In applying this principle, White House economic advisor Peter Navarro’s appearance on television during the market sell-off on June 25th, informing viewers that there were "no plans" to impose restrictions on foreign investments, prompted a market rebound. Similarly, on June 29th, Treasury Secretary Steven Mnuchin pushed back on a news report that President Trump was discussing a withdrawal from the World Trade Organization.

What are the next steps? We know that the US President has threatened new tariffs of an annual trade value of USD200bn on Chinese goods. It has to be seen whether the US will open an investigation in that direction, which would not be implemented before this fall, leaving ample time to negotiate.

The US President has already instructed his administration to look into Section 232 risks to national security from finished automobile and auto part tariffs. The next trade action on auto and parts imports (representing USD176bn in 2017) could see its investigation completed by late summer / early fall with implementation in Q4. This will likely shift the focus away from China towards Mexico, Canada and the EU. Again, there is room for negotiation and EU Commission President Juncker’s trip to Washington later this month is part of this process.

Further out, and on the eve of the mid-term elections, US sanctions on Iran will come into effect by November 4th. The US has repeatedly said that it will impose sanctions on those countries that continue to deal with Iran after that date. In terms of market sectors, the oil & gas sector is expected to benefit from those threats.

Asset allocation implications. Post-correctionvaluations are attractive while the Q2 earnings season is likely to show solid earnings growth. In particular, US equities are supported by the tax reform, buybacks and an attractive valuation vs. bonds. Once current headwinds from a strong USD and aggressive trade war rhetoric settle down, we expect Emerging market equities to benefit from continued strong global growth and attractive relative valuations. Our preference goes to EM Asia, the cornerstone of the high weighting of the tech sector (28%). In Europe, we prefer small and mid-caps to large ones as they are somewhat sheltered from trade war risks, being more sensitive to robust domestic demand and less sensitive to FX. Sector-wise, domestics such as Telecom Services, Utilities and Healthcare appear quite immune to trade conflict risks.

Overall, the Trump administration will try both to achieve solid domestic growth and to entertain an aggressive rhetoric on trade over the coming months. Clearly, the implementation of higher tariffs and the possibility of wider protectionist measures represent a key risk but this should be seen in a context of strong US growth and the upcoming mid-term elections in November. Trade war risks are increasing and these risks are hitting the global expansion via lower confidence, but the cycle remains self-sustained and not easy to derail.