Trade war fallout can hurt risky assets

Putnam Fixed Income Team, 06/14/19

Trade war fallout can hurt risky assets

  • U.S. and China spat blurs the lines between trade and national security
  • Mexico tariff threat signals the United States is unpredictable as a trade partner
  • The probability of a recession is rising, but is still low
Both sides are expanding the conflict

The trade war looks more worrying now for two reasons. First, China’s refusal to offer significant concessions has caused the conflict to expand. Second, national security issues between the United States and China have come into play after the Trump administration imposed measures against Huawei Technologies, the Chinese telecom giant. And there are reports that Chinese students are facing difficulties in obtaining visas to study in the United States. This in turn has prompted threats of retaliation. China has raised the possibility of imposing an embargo on the exports of rare earth minerals, which are essential for a variety of industries.

If China follows through on its threat to restrict rare earths exports, it will severely affect U.S. manufacturers. An embargo is a quantity restriction, not a price change. (The restrictions that the United States has imposed on Huawei are an example of how different it is to prohibit transactions from taking place rather than just changing the prices that consumers pay through tariffs.) Since there are so few rare earth processing facilities outside China, non-Chinese supplies could not make up the shortfall, no matter the price. Quantity restrictions are much more damaging than price changes in a world with highly integrated supply chains.

“Overall, it looks to us as though China is settling in for a long-drawn-out dispute with the United States.”

Overall, it looks to us as though China is settling in for a long-drawn-out dispute with the United States. Beijing may even be prepared to wait until the next U.S. election to see whether it needs to negotiate seriously with President Trump. Chinese domestic politics are as sensitive to “caving to U.S. pressure” as U.S. politics are to signing a “weak deal.”

U.S. policy has grown more unpredictable

President Trump’s plan to impose tariffs on Mexico, now averted, was driven by the “crisis” on the border. Reports suggested these measures were taken with minimal review of their likely effects and against the advice of U.S. Trade Representative Robert Lighthizer. Trump suspended the tariff plans on June 7 and announced via Twitter that the United States had reached an agreement with Mexico to reduce the flow of migrants.

Still, those proposed tariffs on Mexican goods differed from other trade threats for a number of reasons. First, they linked tariffs to non-economic policy objectives. Second, they invoked emergency presidential powers that had never before been used to impose tariffs. Third, they would have greatly complicated trade flows across the U.S.-Mexico border because of the supply chain linkages between the two economies. Fourth, the proposals would have violated of the North American Free Trade Agreement (NAFTA). It will complicate the ratification of its replacement, the U.S.-Mexico-Canada Agreement (USMCA), by lawmakers in the United States and Mexico. Fifth, the plan will reduce the willingness of other countries to reach agreements with the United States.

The President’s campaign promises included plans to curb immigration, to build a border wall, and to review trade deals. But bringing together two of these signature issues could put the economy at risk.

Trade spats may linger

As a result, we are much less optimistic that the trade conflicts will go away. There remain unfinished trade agendas with Japan and the European Union, which could affect the auto industry. The auto sector, which will suffer if the United States imposes tariffs on Mexico, will be challenged further if the United States taxes vehicles from Europe. The auto industry is large and globally integrated — large enough to be of macroeconomic significance — and is already struggling with sales that are either flat or dropping in most major markets.

Trump has surprised in the past and will no doubt surprise us again in the future. So, we cannot dismiss the idea that the President may find a way to make peace on the various trade battles. But the political incentives seem to be shifting as the election campaign season approaches. We think it will be prudent to expect the simmering trade war to continue.

Risks are rising

We believe the risks to the economy are rising. Growth is slowing, and policy risks (trade) are rising. The markets for risky assets are nervous. It would not take much to tip the economy into a weaker path. In this sense, the probability of a recession on our favored models appears much more likely to rise than to fall.

317600