Investors sweat as game of chicken over trade heats up

No one wins from trade protectionism and the return of Tariff Man, and retaliatory measures from Beijing will only exacerbate what was already shaping up as a testing period for financial markets and investment portfolios.

Equity markets began May showing signs of fatigue after a powerful rebound in recent months. That’s hardly surprising given that asset prices need to see stronger evidence of a resilient global economy, thereby signalling the current cycle has room to run longer.

That now looks a far tougher challenge after the US jacked up tariffs on $200bn of Chinese imports on Friday, a move foreshadowed by President Donald Trump last Sunday who duly rattled financial markets this week. An escalating trade war after a hiatus of several months takes us back to the final quarter of 2018, when markets approached the brink, only for central banks to come riding to the rescue.

A growing risk is that Mr Trump won’t just stop with this latest escalation. There’s the threat of extending US tariffs to all Chinese imports and Washington trade hawks are circling Japan and eyeing Germany and the wider eurozone.

The prospect of a further hit to international trade comes at a time when the global economy needs all the help it can get. Over the past year the cost from US and Chinese tariffs has been accompanied by stalling trade flows and left its mark on the global economy, notably for China, Japan and Europe.

But a moderating pace of US growth from last year’s stimulus-fuelled heights also leaves its economy vulnerable to trade stress beyond the already suffering agricultural sector. On Wall Street, the S&P 500’s dominant and most profitable sector, technology, faces a challenge given that more than half of its sales are generated outside the US, by far the highest of any major industry in the index.

For investors, the two big macro concerns framing their risk allocation decisions for 2019 and beyond is whether China’s stimulus flows into the global economy, and have central banks done enough to support a rebound in activity after their new year policy pivots. Further trade protectionism leaves the global economy, together with elevated asset prices and a massive rise in debt over the past decade, looking ever so vulnerable as the recession clock ticks a little louder.

Among investors and strategists there is a view that, for all the political posturing, it serves the interests of both the US and China to avoid a game of chicken over trade. Others take comfort that, so long as the US and China keep talking, the path is open towards an agreement.

Expectations of an eventual agreement help explain the limited weakness in global equities this week. But the debate over who has the stronger hand at this poker table, and hopes of a “beautiful” trade agreement, misses a far more important point.

Tariffs are likely to stay as the struggle for dominance between the world’s two largest economies runs well into the next decade. Any treaty on trade that eventually emerges will probably not pass enforcement over time. Moreover, Mr Trump and US trade hawks have plenty of company across party lines. Heading into the 2020 election cycle, being “tough on China” is seen as a vote winner.

A more troubling long-term view for investors is the onset of a more profound change. After several decades of globalisation — an era where companies have created complex supply chains for goods, services, staff and capital — the lights are dimming. True, supply chains will probably shift from China to other countries, but the disengagement between Beijing and Washington has broader repercussions.

Alan Ruskin at Deutsche Bank says this entails less US foreign direct investment into China, while Beijing will seek to avoid enlarging its already massive holdings of US dollar-denominated assets.

One of Mr Trump’s troubling legacies is far larger federal debt, with the red ink rising relentlessly over the coming decade. The likely scenario of weaker growth and the risk of a recession within the next few years will only exacerbate the pressure on US finances and hit the value of the dollar and the Treasury debt market.

As the largest foreign holder of Treasury debt, China is not going to spark a meltdown by dumping its holdings. But, over time, Beijing’s steady running down of its US assets looms as a slow-burn retaliatory measure that will resonate, particularly when the dollar weakens and Wall Street looks out at a world where China and other US trading partners recycle far less of their reserves across the Pacific.

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