What does a trade war mean for US macro fundamentals?

Article | 02 August 2018 | Invesco Fixed Income

 

In recent weeks, the prospect of a global trade war has emerged more clearly and presents major consequences for global markets. While the implications are difficult to assess, a tightening of financial conditions could be strong enough to significantly curtail US growth.

Scope of US tariffs widens

The potential for a trade war went from rhetoric to reality on July 5th when the Trump administration levied tariffs on USD34 billion of Chinese goods.1 Tariffs on another USD16 billion of Chinese goods related to the initial USD34 billion is likely to take effect later this summer.1 The Trump administration has begun preparations for an additional round of tariffs on USD200 billion worth of Chinese goods2 and the administration has reportedly indicated that it is prepared to tariff a further USD500 billion of Chinese goods.3 In addition to these China-related tariffs, the US government is preparing to impose tariffs on foreign made cars. Car tariffs would be directed globally, including at Europe and Japan, and would represent nearly USD275 billion worth of goods.4

With these developments, the prospect of a global trade war has emerged more clearly and presents major consequences for global markets. The implications of a trade war are difficult to assess. Because the past 30 years have consisted of generally expanding trade liberalization and global trade, we are left with limited information on how financial markets would likely respond.

We believe an intensified and prolonged global trade war would affect global markets in three ways. First, valuations of major currencies would likely adjust with changes in global terms of trade. Second, a trade war would likely bring down global growth and third, asset prices would likely be subject to greater volatility.

Tariffs will likely hurt US growth, but how much?

A global trade war would likely damage US growth, but it is difficult to assess how much. Because one benefit of trade is access to lower cost goods, trade restrictions imply a switch to higher cost goods. Switching to higher cost goods means higher consumer costs and lower inflation-adjusted incomes. Higher producer input costs could also be passed on to consumers. Each of these outcomes could dent consumption and ultimately growth.

In theory, product and input substitutions would limit the negative impact on growth. However, in reality, difficulty in quickly replacing newly tariffed goods means that sudden increases in trade restrictions would likely have an immediate impact on many of the global supply chains that have developed over the past 20 years. Disrupting global supply chains could create an economic shock that significantly lowers growth and productivity. However, the full impact remains unclear. To illustrate the differences in forecasts of the potential impact of a trade war on US growth, Goldman Sachs estimates a contraction in growth of 0.1% while UBS estimates a drop of 1.0%.5

Currency markets likely to feel the most direct effects

Some of the most significant impacts of the trade war are likely to manifest themselves in the currency markets. Increased trade restrictions will likely hurt currencies of countries whose current account deficits are pressured higher or whose surpluses are eroded due to altered terms of trade. Higher US tariffs on China would likely cause a decrease in China’s current account surplus and the renminbi's trade-based valuation. The impact on the US dollar would likely be positive as the US current account deficit would potentially decrease under more protectionist policies. An increase in the value of the US dollar could accelerate if US trading partners use their currencies as retaliatory tools. China could intervene in foreign exchange markets, for example, to lower the value of the renminbi and boost the competitiveness of its exports. A further fallout of a trade war could be a decline in investor confidence resulting in a surge in Chinese capital outflows, leading to potentially sharp currency revaluations.

Second order effects could pose biggest risk: financial conditions tightening

The biggest risk, in our view, from further rounds of tariffs is a tightening of financial conditions, which could be strong enough to significantly curtail US growth. Financial conditions tend to tighten when asset price volatility is high. It is possible to envision a scenario in which the secondary effects of tighter financial conditions outweigh the initial impact of the trade restrictions themselves. Changing tariff rates, for example, could cause speculation that certain companies are at greater risk of default, leading to increased equity volatility and credit spreads. In this scenario, financing costs could rise for the entire US economy. Tighter financial conditions would likely decrease growth unless policy makers stepped in to stabilize them.

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1 Source: The Washington Post, “U.S. levies tariffs on $34 billion worth of Chinese imports”, July 6, 2018.

2 Source: CNBC, “Trump administration announces list of tariffs on $200 billion in Chinese goods”, July 10, 2018.

3 Source: Reuters, “Trump threatens tariffs on all $500 billion of Chinese imports”, July 20, 2018.

4 Source: Goldman Sachs, Economics Research, Dissecting the Effect of Tariffs on US-China Trade, July 9, 2018.

5 Source: Goldman Sachs, Economics Research, The Trade War: An Update, June 25, 2018 and UBS, Global Research, Trade Wars-What is the impact on growth, inflation, and financial markets? A Top Down view.

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