With trade disputes ratcheting up, I’ve had many many questions about the impact of trade uncertainty on market actors and businesses, including whether markets are overpricing risks given the strength of global growth and final demand. Others have wondered if financial markets are underpricing risks. As trade threats (bark) move to partial implementation (bite), and uncertainty about implementation weighs on already slowing industrial output, I continue to expect a slowdown of global economic activity, including in Asia, but I see these trends as more concerning over the medium-term as it is harder to make investment decisions.
This note surveys some of the impacts of trade policy uncertainty, considers some policy response and highlights a few market implications.
Market implications: Overall, recent trends suggests continued returns on risk assets as the one off-benefits of tax measures wane and high US P/Es are less sustainable. Selective USD strength continues as Fed remains on course, and inflation does little to sway major European and Asian central banks. Easier Chinese policy contributes to some stabilization of local macro if not markets, limiting risks to Asian countries, suggesting weaker FX, but better earnings, and suggests that investors should be selective in the EM space, including countries where one is better paid for risk – Russia, from a credit perspective, though sanctions weaken the risk reward as mid-term politicking, and to a lesser extent Mexico and Colombia. Countries with less mispricing but improving balance sheets, include GCC (ex Bahrain), Indonesia and South Africa, though the risk reward is only of limited attraction. Nimble investors may find value in countries undergoing defensive hikes including Argentina, but I believe better entry points may be ahead. It looks too soon to call Turkey cheap.
So what is likely to be the macro impact of trade policy uncertainty? How should it adjust the baseline growth? Recent global outlooks seem to converge to a concern we’ve had for some time about the stalling of growth momentum.
Trade policy uncertainty, by making supply chain costs harder to predict, is likely to reinforce what was likely to be a cyclical slowdown in 2019/2020 in the global economy. Key to this moderation is the continued slowdown towards potential growth in China and Europe, fading of some of the fiscal sugar rush in the U.S. and exit from very easy monetary conditions. In the baseline scenario, trade restrictions and uncertainty of supply chain costs are only likely to make this more complicated.
We have had many years of recovery, and output conditions in Europe and much of Asia look to be “as good as it gets” – absent major policy shifts. Meanwhile tighter financial conditions are likely to hold back regions like latin America and even MEA, suggesting a slower exit from their downturn.
I’ve been concerned for some time that trade uncertainty would make it harder for businesses and indeed households who likely bear the brunt of cost volatility to plan. FX would likely be a major vector of transmission , but uncertainty about supply chain costs, might exacerbate the impact of the tightening of global liquidity implied by the exit of central banks from super-accommodative policies.
How to interpret uncertainty?
I’m not suggesting that trade barriers are the only or even primary driver of business decisions, but uncertainty might cause some businesses to hold off on making investments that were already iffy. It might also increase a trend towards deepening of domestic supply chains, which would shift some of the winners and losers in the global economy. Finally it might add to the trend of more consumption rather than investment driven global growth. This seemed a particular risk for countries such as Canada, that are very exposed to U.S. markets, and where the central bank has been concerned that trade uncertainty might be adding to already sluggish business investment.
One of the biggest questions of the last few years has been when/if trade policy uncertainty might impact global and U.S. growth (see my podcast with hidden forces for a detailed discussion). We may be reaching that time, more so outside the U.S. the U.S. than inside it due to regulatory choices, and fiscal trends, however, U.S. consumers and businesses will be on the receiving end of blowback also. Remember, than sizeable earnings of the S&P 500 are from foreign profits.
US policy trends: Decent Growth, Far From reaching Trade Goals
Recent framing of the U.S. numbers suggest that fiscal stimulus is prompting more of an impact on growth and providing a cushion for administration officials, but doing so is supporting imports, making it even harder for the administration to meet its self-imposed trade deficit goals. Moreover the impact on the USD raises some real questions about dollar funding, especially as the US government has increased its issuance in the market, putting pressure on competitors, exactly as the central bank bid is easing or reversing. This suggests that assessing fundamentals will be important, with weaker fundamental countries and companies providing support.
Chinese response: Could it be easing?
The critical response seems to be shifting to a moderately supportive one (monetary, credit) to a more neutral and slightly tighter one over the last year, amplifying the impact of a relatively tighter fiscal stance. The PBoC balance sheet is now expanding at a slower pace (as local exposures offset for lower foreign currency holdings). The output data from Q2 so far show a cyclical slowdown on the investment side, though not on the retail side. the natural reaction of the Chinese authorities would likely to be to take a slightly easier, stance particularly if they were worried about tightening from the U.S. and supply chain disruptions. This would have the side “benefit” of allowing the CNY to reverse recent appreciation against the basket. Now there are signs it is slipping below the basket performance, raising questions about the broader performance of Asian FX and EM FX.
Thus, policies are likely to shift towards implementation of greater restrictions against foreign companies, especially U.S. ones, more focus on deepening local supply chains (a trend that was already happening). Indeed, I’d expect that more major economies would end up lengthening local supply chains, just as major companies look better positioned to work within the new policy uncertainty.
If the Chinese policy stance does turn easier, and depreciation pressure materializes, this poses a challenge for authorities as it might be difficult to fully control. This suggests moral suasion and domestic policies might be used to limit repatriation of funds. Indeed non-tariff barriers, and even some economic coercion for political aims (core interests such as Taiwan and south China sea) may start to move up again. See my colleagues at CNAS for more on some possible moves. Economic and political interests remain connected.
Are we headed for another financial crisis?
Probably not, though downside risks are rising. Several recent reports (UNCTAD, World Bank) put emphasis on policy uncertainty in reducing long-term investments and indeed have highlighted the risk of a sharp, rather than the moderate slowdown I’ve outlined. I’m not sure trade protectionism can take the full blame here for weaker fixed investment, though it may complicate things.
Domestic Policy uncertainty around fiscal policy, domestic prices and utility tariffs or infrastructure caps investment in Brazil (though recent IIF analysis on FDI suggests that risk may be overstated) as does expropriation risk in Russia, Saudi Arabia etc. these can add up. in general we have seen much more portfolio debt flows than equity and more short term than greenfield or even brownfield investment. This reflects questions on the business environment at home as well as demand at home and abroad.
I was asked a few weeks ago about worries that trade protectionism would lead to a 2008 like recession. That’s always possible, but I find it hard to see the vector for such a sharp contraction in credit and inability to access global demand. Major tariffs would likely be absorbed through Fx swings and some short FX positions would be stopped out. I don’t see as much shadow banking risk or potential for collapse in counterparty risk as in 2008. That’s not to say that Macro outlook would be great under a tit for tat trade environment between U.S. and China but the outcome might be more gradual. Key to watch is the policy moves of the Chinese government, especially given the sizeable increase in debt and continued quality of growth issues.
I think there is likely to be a modest drag to business investment outside the United States particularly in the Americas and Europe and some higher cost Asian producers. This is because the tariffs reinforce some other concerns about final demand- and on the margins tax measures have made it somewhat cheaper to locate operations (finance, services) in the us.
Then what tariffs matter a lot. Steel and aluminum tariffs will add to inflation and have a modest growth drag, but pretty limited and even NAFTA withdrawal will only somewhat disruptive in the near term with greater impacts in the medium term. I would be more concerned about the impact of sizeable tariffs on Chinese trade which would have greater impact on global supply chains including a drag of up to a percentage point on us growth and more on some of its trading partners. This is a major reason why it may not get implemented in full. Along the way, it will be harder to plan and financial and other investors may remain more wary. Coupled with concerns about current valuations, justifying current P/Es looks difficult. Investors should prepare for more moderate returns and wider spreads. Countries with more sustainable fiscal and external positions may provide opportunities – especially among oil producers – GCC debt (ex Bahrain), Russia, Colombia and tactically Mexico. Within Asia, Indonesia looks better positioned on the local debt side.
Ziemba Insights 