Trade risks have flared up recently. Limited trade actions—such as the U.S. steel and aluminum tariff decision—so far have not been big risk-off catalysts. We see such actions as unlikely to hurt the risk-on sentiment or unravel the low-volatility market regime. Yet a potential escalation into trade wars is arguably the most disruptive geopolitical risk to the global expansion and markets in 2018.
How will trade tensions affect markets?
We look into the immediate market reaction around six major trade risk events since 2002 in the chart above, ranging from U.S. steel tariffs and major World Trade Organization showdowns. Gold and yen, two traditional safe-haven assets, outperformed. Chinese stocks—consumer durables and automakers in particular—suffered the heaviest losses. Global equities weakened around these events in general. We note that the different nature of each trade-related event could trigger different reactions—and that an actual trade war would have a much greater impact on a range of assets.
Words turn into action
The U.S. move to impose steel and aluminum import tariffs has turned U.S. President Donald Trump’s words into action, spurring a debate on global protectionism. It is significant because the challenge to the global trade system emanates from the world’s top economy and erstwhile champion of free trade. The market impact will depend in part on the response of U.S. trading partners. The European Union (EU) has threatened retaliatory measures against a set of iconic U.S. goods. Trump in turn threatened further measures against European carmakers. This previews the risk of tit-for-tat responses down the road. More alarmingly, the EU could apply some of the proposed counter-measures to all of its trading partners, potentially adding fuel to the global protectionist trend.
A major risk would be any direct U.S. action against China. The U.S. has been investigating China’s intellectual property practices. If this leads to targeting of Chinese companies, we expect China to retaliate proportionately. This could escalate U.S.-China tensions in the short term, although we expect China to make serious efforts to avoid a trade war. Over the medium term, we see China addressing its trade deficit with the U.S. by opening up its market to more imports, rather than slowing exports. Another flashpoint is the potential U.S. withdrawal from the North American Free Trade Agreement (NAFTA), should attempts to renegotiate the pact fail. We believe a withdrawal is unlikely, but if it were to happen we could see Mexican and Canadian currencies plunging and global risk assets selling off.
For now, we see limited trade actions as unlikely to affect sound market fundamentals, with any volatility spikes around protectionist measures likely to be short-lived. The robust global growth environment supports the low-volatility regime and risk assets. We would reassess our view should the rise of protectionism start to harm global growth prospects. In such a case, we believe emerging market currencies and equities would be hit hardest, triggering a global flight to perceived safe havens such as government bonds and the yen. Over time, trade frictions could disrupt global supply chains and raise the cost of imports, leading to inflationary pressures. This could increase the pace of the Federal Reserve’s monetary policy tightening.