Despite a buoyant economic and earnings backdrop, markets have struggled to get their mojo back since the early February stock swoon. Among the likely explainers, the risk of a trade war is front and centre.
Financial markets have been held in thrall of tit-for-tat trade actions between the US and China. Recent US negotiating tactics have followed a consistent pattern: sweeping headline announcements that have spooked markets, followed by compromises and narrow, if any, implementation.
Signs of willingness from both sides to negotiate a deal has catalysed a recent recovery, but deeper unease persists as the world’s top economy and erstwhile champion of free trade has turned into its key challenger, potentially heralding a major reversal in the US-led opening up of global trade over the past 70 years.
Global growth
Global trade has underpinned growth and rising living standards over the past few decades, and its influence on global growth goes beyond the physical exchange of goods and services.
Sentiment plays an outsized role: the confidence channel tied to trade serves as the conduit for shocks to spread across countries in the form of higher risk premium demanded by investors on all but the safest assets.
An adverse turn in sentiment could also be detrimental to the recent pick-up in investment seen across developed markets (DM) in recent quarters, and underpinning strong growth in emerging markets (EM).
The chart shows that if global integration were to slip back to the levels seen in the mid-2000s, the EM export boon from DM capital expenditure would shrink by half. Such a disruption has the potential to weaken EM growth while stoking more overheating and inflation in cyclically advanced economies – especially if rising trade barriers mean less DM demand leaks abroad via imports.
Key points
- The risk of a trade war between China and the US has spooked markets
- For now, trade measures that have been implemented are limited in scope
- Several options are available to China to change its trade relationship with the US
For now, the trade measures that have been actually implemented are limited in scope. Indeed, some of the trade news flow has even been positive, for example on the prospects of a new North American Free Trade Agreement or even the US re-joining the Trans-Pacific Partnership.
The macroeconomic backdrop remains strong across all parts of the global economy, even if the most recent batches of data releases have disappointed – they remain at very healthy levels. Growth leadership is shifting: after Europe and China were the big positive surprises in 2018, we believe that the US holds the largest potential among major economies for further upside growth surprises over the coming year, with tax cuts and public spending set to add about one percentage point to growth this year, in our view.
Escalation into a trade war could deal knock-on blows to sentiment and change our view. Rising tensions would have broad economic implications that go beyond bilateral trade. Components from abroad represent nearly half of Chinese manufacturing exports, according to Organisation for Economic Cooperation and Development data, with Europe, Japan and South Korea all acting as big component and intellectual property suppliers to China for goods that are subsequently re-exported. US tariffs on China – and any resulting retaliatory measures – could cause widespread economic fallout by affecting such global supply chains.
Tension
For now, our base case is one where increasing economic tensions between the US and China spark bouts of volatility but without derailing the benign economic and market backdrop. Several options are available to China if they wish to make the trade relationship more reciprocal – a key US demand – and to help trim the US trade deficit.
These include opening up service sector foreign ownership limits; reducing import taxes; loosening technology transfer requirements for direct investments; and increasing US imports.
Chinese president Xi Jinping’s recent speech during the opening of the Boao Forum for Asia encouragingly indicated willingness to consider steps in this direction.
It should however be stressed that while it is probable that agreements will be found on some of the narrow trade issues at stake, and at least some of the announced tariffs will be avoided, a key focus of US policy appears to be countering China’s intellectual property practices and general aspiration to be a global leader in the tech sector. These issues are less likely to find a quick solution, and as a result an elevated level of tension is likely to endure.
More generally, we see greater economic uncertainty ahead after a stretch of unusual calm. Hefty US fiscal stimulus brings positives but also a wider array of possible outcomes on both the growth and inflation front, including a risk of overheating that would force the Federal Reserve to choose between an abrupt tightening and a meaningful inflation overshoot. This risk would be magnified by a protectionist turn in US policy. Stronger capital spending and productivity growth can spur upgrades to potential growth and contain any overheating, yet such an outcome is far from certain and will take time to materialise.
Confidence
Overall, the global economy continues to be strong in all its parts, and we remain confident that the market will reward risk-taking, especially in equities. If anything, the market moves since February have helped flush out crowded-positions and excessive valuations.
Still, uncertainty is higher than even a quarter ago, for both macroeconomic and geopolitical reasons, and volatility is unlikely to return to the exceptionally low levels recorded last year. By contrast, we are generally negative on government bonds, albeit the short-end of the US Treasury curve has now repriced sufficiently to offer an attractive risk-reward package.
Isabelle Mateos y Lago is chief multi-asset strategist at the BlackRock Investment Institute
