Staying positive while protectionism rears its head

By Stéphane Monier Chief Investment Officer Lombard Odier Private Bank

Protectionist rhetoric from the US has sparked important questions about the motivations, intentions, and dangers that might lie behind the words. For now, a full-blown trade war appears unlikely despite President Donald Trump’s proposed tariffs on metals imports, but the potential threat has been clearly signalled by talk of rapid retaliation from trading partners.

Unpredictable

Trump signed an order on 8 March calling for a levy of 25% on steel imports and 10% on aluminium. It was telling that he did so surrounded by workers from both industries, for this should be seen as much as a political move as it is an economic strategy. In fact, Trump administration officials have clarified that exemptions handed to Canada and Mexico depend on a favourable outcome in renegotiations of the NAFTA trade deal. Trump has also opened up the possibility of further exemptions for countries which have something to put on the table. In short, it is the kind of hard-nosed deal-making that Trump considers his key strength, but which can lead to unpredictable outcomes.

The European Union issued one of the more robust responses, publishing a list of iconic US products – including Harley Davidson motorcycles and Bourbon whiskey – on which it could slap retaliatory import taxes. China’s commerce minister Zhong Shan, meanwhile, has warned that a trade war would be a disaster for the world, with “no winners” – giving us the intriguing image of communist party officials lecturing the US on free trade.

The reassuring glow of the US’ sound fundamental economic dynamics has allowed the markets to respond calmly, so far, to the escalation in tensions. Investors appear to have settled on the idea that Trump is trying to strengthen his hand in trade talks, rather than wielding an iron fist. However, Trump’s 12 March decision to block Singapore-registered Broadcom’s hostile takeover bid for rival chip maker Qualcomm does amplify the protectionist tone of his administration. The departure of secretary of state Rex Tillerson on 13 March further adds to uncertainty about policy direction.

And, of course, it is never easy to control outcomes. This is particularly the case for the labyrinthine intricacies of global supply chains, the disruption of which could have grave consequences for the US as much as anyone else. Therefore, it is worth considering the implications should trade become a weapon. Economists at financial news agency Bloomberg have estimated that a broad 10% tariff on goods worldwide could wipe 470 billion US dollars (USD) off the global economy by 2020¹.

Lessons from the past

The US has long wrestled with its trade deficit. In the 1980s, the US embarked on a protracted effort to get Japan to open up its markets to US goods, but by 1989 Japan accounted for close to half of a then more modest trade deficit of just over USD100bn². The administration of President Bill Clinton took a hardline stance through the early 1990s to try to end what it saw as imbalances, but ended up ditching many initial demands in a fumbled compromise, as the need for a strong political alliance became a more pressing motivation. Back in the present, the trade deficit with Japan has been steady at about USD68bn for the last four years.

And if we look further back, to the deeply protectionist US response as the Great Depression took hold, the dangers are even more clear. In 1930, the US raised duties on hundreds of imports as it sought to shelter industry and agriculture from competition. What it got was a trade war which essentially shut down global trade and certainly extended the pain at home.

It remains true, however, that amid all the speculation and political positioning around metals tariffs lies a genuine issue. The US trade deficit with China last year came to a record USD375bn³, more than three times what it was 15 years ago and representing a huge chunk of the US’ total deficit, which now dwarfs that of 1985. One of Trump’s key pledges as a “protectionist” presidential candidate, and since taking office, has been to address what he calls that “unfair” balance. Remember that trade deficits have to be funded by debt, and can often indicate declining competitiveness.

However, it is hard to see how aluminium and steel tariffs would address this in any substantial way. Many analysts have pointed this out, with ratings agency Moody’s Investors Service noting that Chinese steel and aluminium imports to the US account for less than 0.1% of Chinese GDP⁴. Tariffs on other goods such as electronics components would only serve to increase the cost of production in the US. A currency war might be tempting as an alternative solution, but looks similarly unwinnable and is complicated by China’s large holdings of US debt as well as by the fact that the US has sizeable deficits with other regions, including the European Union and Mexico (see graphic below). It is perhaps more useful to note a report in the Financial Times which claimed the Trump administration sought to encourage China to import more cars, aircraft, soybeans and natural gas in the immediate wake of the tariffs announcement⁵.

Portfolio protection

This means that we might perhaps take Trump at his word. At the World Economic Forum in Davos, he was careful to add a caveat to one of his campaign slogans, so that the message became less overtly protectionist: “America First, not America Alone.” There is a valid argument that the US is relatively poorly served by the structure of its trade agreements and our belief is that some clear wins for Trump on this level could quickly curtail the threat of rampant protectionism.

Both history and the present-day dynamics mean there is little sense in the US sparking a tit-for-tat battle over tariffs. At the same time, China’s ambitious One Belt One Road project – the so-called “New Silk Road” to build infrastructure networks through Asia – offers a significant indication of its own commitment to free trade. Our central scenario remains positive, and we maintain a pro-growth stance that favours equities and emerging markets. We took the decision to use the recent pullback in equity markets to add another 1% equity exposure while reducing credit exposure. Clearly, though, a trade war would be a major risk to this scenario and would force us to adopt a very defensive stance, reducing equities exposure and emerging markets weightings and favouring defensive assets such as index-linked bonds. Even if they develop into nothing more worrying, the current heightened trade tensions support our expectation for a period of elevated volatility compared to 2017. That could be an environment in which agile and disciplined investors can prosper while politicians posture.

¹ https://www.bloomberg.com/news/articles/2018-03-12/trump-s-trade-war-and-the-470-billion-hit-to-the-global-economy
² https://www.census.gov/foreign-trade/balance/c5880.html
³ https://www.census.gov/foreign-trade/balance/c5700.html
⁴ https://www.forbes.com/sites/ralphjennings/2018/03/05/china-will-laugh-at-trumps-us-steel-tariffs-for-now/#59f80e165a94
⁵ https://www.ft.com/content/75df0300-24e4-11e8-b27e-cc62a39d57a0