As trade frictions escalate, how should investors view the implications of increased protectionism? A look at three possible trade policy scenarios.
As trade frictions dominate the headlines, markets have had to react to near-daily developments, assessing the impact that tariff measures by the U.S.—and the response by trade partners—could have on global growth.
Amid this cloud of uncertainty, investors must suddenly confront the possibility of increased protectionism, the severity of the measures and its effect on regions, companies and impacted sectors.
“Our base case economic narrative for 2018 called for continued global growth, with a recovery in the capex cycle supporting global trade. We think that this strong starting point of underlying global demand will help to offset the rising U.S. trade policy uncertainty,” says Chetan Ahya, global co-head of economics at Morgan Stanley Research.
In a report from Morgan Stanley Research, Ahya and his colleagues outline three possible outcomes to help investors navigate the implications from a rise in trade frictions.
In this scenario, the U.S. and China would agree to cut the U.S.-China trade deficit by $100 billion (4% of China's exports and 4% of U.S. total imports), resulting in a de-escalation of the situation. Recent reports indicate that China and the U.S. have begun negotiating, with the U.S. seeking improved access to Chinese markets and lower tariffs on U.S. cars among other discussions.
On March 22, the Trump Administration announced plans to pursue Section 301 of the 1974 Trade Act which outlines measures to respond to “unfair trade practices”—in this case, what the Trump Administration believes are intellectual property infringements on the part of Chinese companies.
Under this plan, the U.S. is expected to impose a 25% tariff on $50 billion to $60 billion in annual imports from China. The proposed list of products subject to higher tariffs is expected to be delivered by early April and is likely to affect such sectors as aerospace, communication, machinery, robotics and technology. The U.S. is also expected to roll out new restrictions on Chinese investments related to those sectors.
If these plans were to be implemented, Morgan Stanley estimates that this level of protectionism would dampen China's export growth by 0.7 to 0.9 percentage points and would reduce China's GDP growth by 0.12 percent points to 0.14 percentage points after factoring for spillover effects.
Following the U.S. announcement to extend tariffs, China indicated that it would put up additional barriers of its own, with tariffs on 128 products representing about $3 billion in U.S. imports, including fresh fruit, steel pipes and pork. While this could have real consequences for some U.S. exporters, it would not directly impact the broader U.S. economy.
However, the possibility of U.S. and China negotiating a deal that moves in the direction of resolving the dispute remains in the works as indicated by recent reports, which would therefore mitigate the impact on both economies.
Under this “protectionist push" scenario, the U.S. would implement a tariff hike across all Chinese manufactured goods, and China would lob a commensurate response. This would have the strongest impact. Morgan Stanley U.S. chief economist Ellen Zentner estimates that a 20% broad-based tariff increase could, after four quarters, result in a 1 percentage point drag on real U.S. GDP growth. Morgan Stanley China economist Robin Xing estimates a similar impact on real GDP growth for China.
Just as critical as the direct impact of widespread tariffs are the reverberations across other markets. “The impact of this widespread use of Section 301 would extend and be amplified by global value chains, which account for two-thirds of global trade, and tighter financial conditions," says Ahya. Companies adjusting their own strategies as a hedge against rising protectionism could further stifle growth.
As it stands, the current level of tariffs on the table should not have a material effect on the current trajectory of global economic growth. “Our base case of stronger for longer growth remains intact, unless we move into an aggressive protectionist push scenario," says Ahya.
That said, trade policy is a wildcard and the situation remains fluid. The risk that trade friction could escalate, persist and spill over to other countries has injected a dose of worry into global markets. Accordingly, market movements have reflected the ebb and flow of these concerns.
“Trade tensions don’t dominate our forecasts. But the core of our 2018 outlook is a ‘tricky handoff’ where slowing growth in the U.S. and China occur alongside rising inflation. Trade tensions could make both sides of this handoff worse,” says Andrew Sheets, Morgan Stanley’s Chief Cross Asset Strategist.
If trade frictions were to persist, it could dampen risk appetites and raise volatility for U.S equities, particularly where a late-cycle environment has already led to questions about earnings growth and economic fundamentals.
For European equities, the negative headlines on trade are also a potential drag. Although Morgan Stanley strategists still like the European market overall, they recommend avoiding sectors which have the largest exposure to exports and currency, including autos, chemicals and industrials.
For Asia/Emerging Markets equities, meanwhile, uncertainty over trade protectionism could drive valuation adjustment to the downside. North Asia and Mexico are most exposed to the U.S. in terms of listed equities' revenue sensitivity while ASEAN, Turkey, Russia, South Africa and Brazil are potentially less affected.