A Road Map for Navigating Protectionism: The Elevator and the Staircase
- Financial markets have experienced another bout of volatility, this time related to an escalation in protectionism involving the US and China. An escalation of such tensions towards a full-blown trade war would be very damaging for global growth and certainly for global financial markets. We therefore describe two risk scenarios associated with such an escalation and present a road map to navigate them.
- Globalisation – the increasingly free movement of goods, services, labour and capital – has been a key driver of increased prosperity around the world. However, not all have benefited from this process and some governments, notably that of the US, have started to address trade imbalances as a way to support their dissatisfied electorates.
- A significant reversal in the globalisation pendulum would be very damaging for global growth and for financial markets. But it is still unclear how far back the pendulum will swing as there are institutional hurdles – such as the US Congress, the World Trade Organization (WTO) and financial markets themselves – that may slow down, limit or even stop the current initiatives by the Trump Administration.
- We envisage two possible escalation scenarios. The first is a multilateral trade war, between the United States and the rest of the world. The second is a bilateral trade conflict, between the United States and China. In both cases we envisage a prolonged period of tension. Crucially, we still see the risks of full-blown trade wars as low probability-high impact scenarios.
- What is important for investors is how to navigate an escalation or de-escalation of those risk scenarios. For instance, these situations could escalate rapidly leading to sudden market moves as investors quickly reassess the probability of a trade war. Alternatively, the risks could escalate in steps, for example, if markets perceive that trade tensions may lead to tit-for-tat retaliation. We therefore provide certain signposts that should help investors assess potential shifts in markets as protectionism evolves.
- We also delineate the likely economic impact of trade wars. The combination of tariffs and quotas and the reversal of the globalisation of production and supply chains would likely lead to higher prices, lower productivity, and ultimately lower output. We also examine the likely response of central banks including how they view possible second-round- effects such as workers pushing for higher wages and higher inflation expectations.
- We also gauge the asset price implications of trade wars. We look at financial markets’ responses to oil shocks (used as proxies for supply shocks) as well as recent episodes of protectionist escalation. We conclude that equities are the asset class at most risk. The performance of other asset classes is usually mixed, suggesting that the macroeconomic and policy backdrops matter in terms of shaping markets’ responses.
- As for strategy, we are not altering our base case scenario of strong growth and contained inflation. But while we may believe that the probability of full-blown trade wars is still low (below 10%), we do expect further outbreaks of protectionist tension as the globalisation pendulum continues to oscillate back and forth, and that makes the trading environment riskier. With higher uncertainty or ‘fatter tails’, market volatility and risk premia should move higher. If the trade war scenarios remain at a low probability, it makes sense to hedge portfolios against them with assets that do well in risk-off situations but that do not underperform if these risks fail to materialise.
What the issue is and why it matters
The decision by the Trump Administration to impose tariffs on US imports of steel and aluminium has unsettled politicians, commentators, investors and financial markets – and with good reason. It could be the opening salvo in what turns out to be full-blown trade war. Globalisation – by which we mean the increasingly free movement of goods, services, labour and capital across borders – has been one of the defining features of recent decades and is widely believed to be a key driver of greater prosperity around the globe. National borders have become more porous and the barriers which once prevented the efficient allocation of resources across countries have fallen. The impact on production has been profound. Companies are better able to source labour, outsource production, locate suppliers and service customers across borders. Global value chains have emerged with the production, distribution and post-sale support of goods and services spanning multiple sites in multiple countries. In simple terms, a trade war threatens to throw this entire process into reverse, unwinding the hard won gains in efficiency that globalisation facilitated. Costs and prices will rise and productivity, profitability and prosperity will fall. The impact on financial markets will likely be equally profound.
Although we naturally tend to think about trade wars in terms of the imposition of tariffs on traded goods of the kind announced by the Trump Administration on aluminium and steel, a full-blown trade war could also involve quantity-based restrictions on trade, including imposing barriers on limits, as well as broader protectionist policies covering financial flows, such as influencing the cross-border investment decisions of domestic private and public-sector institutions or ruling against cross-border mergers. In particular, we do not – in the event a severe trade war instigated by the Trump Administration – view as sacrosanct or secure the US dollar’s status in general, and US government debt’s status in particular, as the world’s FX reserve of choice and pre-eminent safe asset. After all, America’s strong dollar policy was always about maintaining the US government’s artificially low cost of servicing debt and it would be naïve to assume that other countries will not use all the levers at their disposal to punish the United States into a full-blown trade war. Our point is simply that trade wars can be about a lot more than just increases in tariffs – and hence even more worrisome.
There are of course a wide range of alternative visualisations of a trade war, which vary not only in terms of probability and severity but also in terms of which parties are involved, the dimensions along which tensions escalate and how persistent the disruptions to trade and transactions may become. In this note we deliberately focus on a couple of tail scenarios that capture two realisations of a severe trade war: one multilateral and one bilateral. Both should be considered highly unlikely to occur, but both would have a significant macroeconomic and market impact if they did occur.
The rest of this note is organised as follows: first, we discuss the ongoing reversal in globalisation in order to answer the fundamental challenge: how could a significant trade war possibly break out if it is crystal clear that it is a lose-lose proposition?; second, we outline the basic narrative of our two tail scenarios and how we consider our base case view; third, we introduce a road-map for navigating these tail risk scenarios that suggests we can adjust portfolios in real-time in response to news; fourth, we discuss the macroeconomic consequences of a severe trade war, focusing in particular on the critical response of central banks to the shock; fifth, we discuss the asset price and portfolio implications of severe trade wars.
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