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Oh, what a lovely trade war!

Oh, what a lovely trade war!

08-10-2018 | Monthly outlook

There is little upside for investors in the escalating US-China trade war, warns Robeco Chief Economist Léon Cornelissen.

  • Léon  Cornelissen
    Léon
    Cornelissen
    Chief Economist

Speed read

  • Trump slaps tariffs on up to USD 250 billion of Chinese imports
  • ECB model shows a general trade war would hit the US the most
  • BoE study shows US output hit by 2.5% and global output by 1%

US President Donald Trump has ramped up the rhetoric about slapping tariffs on billions of dollars’ worth of Chinese imports, while China has responded in kind. The investor response has so far been muted, but this underestimates the true risk of sparking a global trade war, Cornelissen says.

“In recent surveys, investors consistently – you could say routinely – list trade wars as the biggest risk for financial markets,” he says in Robeco Investment Solutions’ monthly outlook. “Apparently, they generally don’t share the view of the US president that “trade wars are good and easy to win”. But now that Trump is targeting half of China’s exports to the US with higher tariffs, markets seem to be shrugging it off. What can explain this paradox?”

Tariffs on Chinese exports to the US.
Source: The Economist

Trade wars do hurt

“The wariness of investors is understandable. The world hasn’t forgotten the lessons of the Great Depression, where gradually increasing protectionism contributed to the length and the depth of the downturn. That is the reason why after the Lehman collapse, the G20 countries agreed to refrain from protectionism, successfully as it turned out.”

“Recent model simulations by the European Central Bank (ECB) suggest that trade wars do hurt. It showed a hypothetical scenario in which the US raises tariffs on all imports by 10 percentage points, and its trading partners retaliate with a 10 percentage-point tariff increase on their imports from the US. The ECB tries to capture indirect confidence effects: bond premiums are assumed to rise by 50 basis points and stock markets to decline by two standard deviations in all countries; for the US, this turns out to be a 16% fall in the stock market.”

“For the US and China, the confidence effects are lower than the direct trade effect, which could be an underestimation. The result is that real economic activity in the US is 2% lower than the baseline in the first year alone (see chart below). Interestingly enough, China gains somewhat, as lower exports to the US are compensated for by trade diversion to third countries, where Chinese exporters are able to gain market share at the expense of the US.”

The estimated effects of a trade war in the first year.
Source: ECB

Hit to global trade

“The conclusion of the ECB echoes earlier Bank of England simulations which suggested that in a similar scenario, US output could take a hit of 2.5% and global output 1% through trade channels alone. The Bank of England noted that the hit to global GDP would be substantially larger if everyone put up tariffs against everyone else.”

Trump’s trade war is also not just confined to China, as he has also threatened the European Union, famously complaining about German BMWs cruising around Manhattan. “Despite an apparently successful visit by the EU Commission president to the US to defuse trade tensions, Trump said at a campaign rally in West Virginia at the end of August: ‘We're going to put a 25% tax on every car that comes into the United States from the European Union’,” Cornelissen says.

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Dizzying numbers

The latest round of US tariffs is a 10% levy on USD 200 billion worth of Chinese goods which came into effect in September, on top of the USD 50 billion that came into effect in August. “Despite the slightly dizzying numbers, the products targeted so far still represent only a small part of world trade,” Cornelissen says.

“It is therefore understandable that the tariffs have not yet significantly damaged producer and consumer confidence. This goes a long way to explain the muted financial market reaction so far.”

“However, further escalation is looming. The US has threatened to hike the 10% tariff rate on USD 200 billion of goods to 25% at the beginning of next year if China doesn’t “change its ways” – though it is still not entirely clear what the negotiation goal of the US vis-à-vis China is.”

Congressional elections

“Trump could become politically weakened in the mid-term Congressional elections on 6 November, but this is unlikely to have much impact on his policies against China, as a hard line against the country is generally popular among the Democratic opposition and also in significant parts of the US business sector.”

“But it could mean that his pressure against Europe diminishes due to lack of support. With an eye on the presidential elections of 2020, Trump could choose to keep political tensions high with China, in the hope that this will increase his re-election chances.”

“Higher tariffs will thus become a permanent feature for the coming years. For investors, there is little upside in the escalating trade war. They can only hope that a more drastic escalation from current levels does not materialize.”

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