Reflecting on trade tensions

Recent developments have turned the prospect of a trade war, which was but a mere hypothetical scenario in the early days of the Trump administration, into a risk worth considering more seriously.

The US has already imposed a series of measures against a number of trade partners. The list so far includes imports of solar panels and washing machines, steel and aluminium, and a broad set of Chinese exports to the US. The North American Free Trade Agreement (NAFTA) is under renegotiation, but the process has proven slow, inconclusive, and often acrimonious. The relationship between the US and most of the other G7 countries appears increasingly tense.

Given the size of the US current account deficit (see chart I, page 04) President Trump’s focus on bilateral trade deficits is bound to lead to numerous targets, whether among security allies such as Japan or Germany, or rivals like China – which has been the primary target of the Trump administration so far. The US complaints have revolved around the size of China’s trade surplus vis-à-vis the US (ca. USD 350 billion (bn) in 2017) but also its industrial policies, including the treatment of US technology and intellectual property.

The first trade blows between the US and China are due to take effect in early July. US tariffs of 25% will be imposed on approximately USD 50 bn worth of Chinese exports, with a similar in scale response to be implemented by China in retaliation. The threat of a second round of retaliatiory measures has also been raised, mostly on the part of the US, which – given the total size of imports from China (ca. USD 500 bn) – have more room for such action.

The impact of tariffs on an economy amount to a typical negative supply shock: output falls while prices rise. Given the current US inflation rate, they are also likely to result in tighter monetary policy. The direct economic cost of the tariffs announced to date is modest, of an order of magnitude of 0.1-0.2% of GDP (Gross Domestic Product). Given the ongoing strength of global trade (see chart II, page 04), recent actions do not pose a severe risk for the world economy. The cost may, however, become more significant in the future, for instance if the tariffs that President Trump has threatened to impose on an additional USD 200 bn worth of Chinese imports or broad-based tariffs on auto imports come to materialise (see chart III, page 04).

Meanwhile, from the perspective of financial markets, pressure on corporate margins and broader business disruption -- from the unravelling of global supply chains, for example -- would be a significant concern. The impact could be amplified by other second-round effects of trade tensions, such as a dampening of business confidence and fixed investment intentions, or a possible wave of risk-aversion that would in turn impact financial conditions.

Market participants have taken comfort in mitigating factors, such as the pressure from the US business community (even within the Republican Party) against protectionist measures and the Trump administration’s own sensitivity to negative market reaction. We think the most reasonable base case is that the trade tensions are likely to remain contained and, thanks to economic self-interest on all sides, a global trade war will be avoided. That said, given recent developments and the stakes involved, a trade war is a risk that investors will need to take into account in their scenario analysis for the foreseeable future.

Note: Unless otherwise stated, all data mentioned in this publication is based on the following sources: Datastream, Bloomberg, Lombard Odier calculation.