How could trade tensions affect global markets?

By Maria Paola Toschi, 22 July 2019

The trade dispute between the US and China shows few signs of resolution. Why are global tariffs rising, which economies are most vulnerable and how can investors position themselves for this more challenging environment?

“At the root of the dispute is the technology sector, and US and Chinese negotiators are unlikely to find common ground.”

Maria Paola Toschi

Since his election, President Trump has sought to correct what he and his administration perceive to be trade injustices working against the US economy. These policies have considerable backing from the US electorate and the Democratic Party. Whilst China is the key focus, there is still a risk that the dispute broadens to the EU. This is weighing on global growth, largely because companies are deferring investment. If a further escalation prompts companies to cut jobs then the risks to this expansion will rise, regardless of more dovish central banks. It doesn’t seem politically optimal for the President to take risks with the expansion given he hopes to gain a second term in November 2020. But our conviction on the outlook for the trade conflict is not high and investors should think about adding assets to a portfolio that will perform in times of market stress.

What is the root of the dispute?

Global trade tensions began in 2018 when the US government imposed tariffs on certain imports, including solar panels and metals-ending a multi-decade process of US trade liberalisation. Since then, tariffs as a percentage of all imports have remained relatively low. But, if the US goes ahead with proposed further charges on Chinese imports and new taxes on auto sector imports, the average US tariff rate will return to levels not seen since the 1940s (Exhibit 1).

The US government’s initial objective was to use tariffs to reduce America’s large trade deficit with China1. However, there are other areas of dispute less directly linked to trade, such as the protection of intellectual property rights and the non-tariff barriers faced by US companies in China.

Exhibit 1 - US effective import tariff rate

% effective tariff trade (tariffs collected as % of all imported goods)

Source: (Left) Esteban Ortiz-Ospina and Max Roser "International Trade", US Census Bureau, US International Trade Commission, J.P. Morgan Asset Management. Currently effective and proposed data are JPMAM calculations. Currently effective tariffs includes tariffs on washing machines, solar panels, steel and aluminium, as well as tariffs implemented on approximately USD 250 billion of China imports. Remaining China imports and global autos (including auto parts) are measures proposed on approximately USD 290 billion worth of goods for each. Past performance is not a reliable indicator of current and future results. Guide to the Markets - UK. Data as of 1 August 2019.

On both the issue of trade and intellectual property the negotiations looked to be proceeding amicably. They have faltered, however, on the issue of the state-led support China provides to its technology industry. While China has demonstrated a willingness to make concessions in “old China” sectors, such as consumer goods, its plans to reshape the Chinese economy are reliant on growth in the technology sector. Therefore at the heart of this dispute is a desire from both sides to be the dominant global player in global technology. The revival of US-China trade talks, announced at the June G20 Summit, was encouraging, but a comprehensive agreement looks unlikely until there is agreement on the technology sector.

What impact could trade tensions have on the Chinese and US economies?

Currently the US has applied a 25% tariff on roughly half of the US imports (USD 250 billion) from China, and have announced that from 1 September a 10% tariff will be applied to the remainder (USD 290-300 billion) of the imports from China. With Chinese exports to the US worth 3.6% of Chinese GDP, the impact on the Chinese economy is increasing. However we are also likely to see a more notable impact on US consumer prices as the products that face tariffs are broadened towards consumer facing goods. To provide support, the Chinese authorities are pursuing a mix of monetary and fiscal stimulus measures aimed at stabilising growth close to the declared target rate of 6%-6.5%.

US exports to China are less than 1% of GDP. Nevertheless, the US manufacturing sector could be hit by higher costs for imported intermediate goods, which can only be partially mitigated by lower Chinese prices or a devaluation of the renminbi. With production costs rising, wages growing and no room to increase final prices, corporate profits would be expected to come under pressure2.

Exhibit 2 shows the correlation between falling world export volumes and S&P 500 forward earnings downgrades. Economic uncertainty and lower profits could further dampen corporate investment and capital expenditure, which have already stalled.

What could be the global impact?

These direct effects of the tariffs are small compared to the indirect effects. Faced with geopolitical uncertainty, companies are deferring plans to invest, which has already caused a global industrial and export slowdown. As a result, the eurozone economy looks particularly vulnerable, given many European countries have export-oriented economies (Exhibit 3). The European Union (EU) is also facing potential higher US tariffs on the auto sector. Currently, cars made in the EU attract a 2.5% US import tariff (25% on trucks and vans), while the EU imposes a 10% duty on US car imports. The US is the top market for European carmakers, with 1,155,500 units exported to the US in 2018-four times higher than US car exports to the EU.

Exhibit 2 – World export volumes and US earnings

% change year on year, export volumes are a three-month moving average

Source: CPB Netherlands, IBES, Refinitiv Datastream, J.P. Morgan Asset Management. EPS is earnings per share. The sharp increase in S&P 500 forward EPS at the start of 2018 is attributed to the Tax Cuts and Jobs Act of 2017, which came into effect at the beginning of 2018. Past performance is not a reliable indicator of current and future results. Guide to the Markets - UK. Data as of 30 June 2019.

Hopes for a reciprocal zero tariff agreement are complicated by the US request to include agriculture in any trade deal, which is rejected by the EU. German carmakers are the most exposed to a rise in US import tariffs, but other EU countries look vulnerable, including Italy, which is also a major exporter of auto components to the US.

Perhaps most concerning has been signs that the US Administration is willing to use tariffs to meet broader foreign policy objectives. Mexico, for example, was threatened with higher tariffs if it didn’t control illegal immigration flows across the US border. US president Donald Trump has also tweeted that China and Europe are playing currency manipulation games, suggesting possible new measures.

Will trade tensions escalate?

It is unclear whether President Trump will ease up on the trade agenda as focused on his reelection in November 2020. Trump would like to be able to point to some achievements from the conflict with China, but he also needs to avoid an escalation in the trade dispute that could lead to a slower economy, weaker equity market and falling corporate profits.

China, meanwhile, has exhausted room for retaliation against US imports but it does have other ammunition. Some have questioned whether China could hit back by selling its treasury holdings. At present, China remains the largest foreign holder of US debt at USD 1,113 billion. However, it is worth remembering that China buys treasuries largely for the purposes of controlling the currency. A significant sale of US Treasuries, of a magnitude sufficient to push up US bond yields, would involve an appreciation of the renminbi. This would compound the problem for Chinese exporters in a world of rising tariffs.

What are the implications for investors?

Trade tensions are weighing on global growth, largely because companies are deferring capex. The measures so far imposed are unlikely to lead to a global recession but should the uncertainty caused by a further escalation cause firms to cut jobs as well as capex, then the risks of recession will rise. Central banks are responding to the weakness with lower interest rates which, alongside increased demand for safe haven assets, has pushed up bond prices, gold and the Japanese yen.

Our core scenario is that it is not in the President’s interest to increase the trade conflict further ahead of the election but there is considerable uncertainty around this view and investors would be well placed to think about adding assets to a portfolio that would be expected to perform in stressed market conditions such as US Treasuries, and strategies less correlated to the equity market, such as macro funds.

Exhibit 3 – Exports of goods

% of nominal GDP, 2018

Source: IMF Direction of Trade, IMF World Economic Outlook, J.P. Morgan Asset Management. J.P. Morgan Asset Management. Past performance is not a reliable indicator of current and future results. Guide to the Markets - UK. Data as of 30 June 2019.

Notes:

1 The US trade deficit versus China of USD 420 Billion is the result of USD 540 Billion of US imports from China and total exports to China of USD 120 billion. Data as of 31 December 2018.

2 According to the June labour market report the unemployment rate was 3.7% and year-on-year wage growth was 3.1%.

 


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Disclaimer

The Market Insights program provides comprehensive data and commentary on global markets without reference to products. Designed as a tool to help clients understand the markets and support investment decision-making, the program explores the implications of current economic data and changing market conditions. For the purposes of MiFID II the JPM Market Insights and Portfolio Insights programmes are marketing communications and are not in scope for any MiFID II/MiFIR requirements specificallyrelated to investment research. Furthermore, the J.P. Morgan Asset Management Market Insights and Portfolio Insights programmes as non-independent research have not been prepared in accordance with legal requirements designed to promote the independence ofinvestment research; nor are they subject to any prohibition on dealing ahead of the dissemination of investment research.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designedto be as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, noris it a commitment from J.P. Morgan Asset Management or any of its subsidiaries to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support aninvestment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their ownprofessional advisers, if any investment mentioned herein is believed to be suitable to their personal goals. Investors should ensure thatthey obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given andnoliability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the incomefrom them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields is not a reliable indicator of current and future results. J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide.

This communication is issued by the following entities: in the United Kingdom by JPMorgan Asset Management (UK) Limited, which is authorized and regulated by the Financial Conduct Authority; in other European jurisdictions by JPMorgan Asset Management (Europe) S.à r.l.; in Hong Kong by JF Asset Management Limited, or JPMorgan Funds (Asia) Limited, or JPMorgan Asset Management Real Assets (Asia) Limited; inSingapore by JPMorgan Asset Management (Singapore) Limited (Co. Reg. No. 197601586K), or JPMorgan Asset Management Real Assets (Singapore)Pte Ltd (Co. Reg. No. 201120355E); in Taiwan by JPMorgan Asset Management (Taiwan) Limited; in Japan by JPMorgan Asset Management (Japan) Limited which is a member of the Investment Trusts Association, Japan, the Japan Investment Advisers Association, Type II Financial Instruments Firms Association and the Japan Securities Dealers Association and is regulated by the Financial Services Agency (registration number “Kanto Local Finance Bureau (Financial Instruments Firm) No. 330”); in Korea by JPMorgan Asset Management (Korea) Company Limited; in Australia to wholesale clients only as defined in section 761A and 761G of the Corporations Act 2001 (Cth) by JPMorgan Asset Management (Australia) Limited (ABN 55143832080) (AFSL 376919); in Brazil by Banco J.P. Morgan S.A.; in Canada for institutional clients’ use only by JPMorgan Asset Management (Canada) Inc., and in the United States by JPMorgan Distribution Services Inc. and J.P. Morgan Institutional Investments, Inc., both members of FINRA; and J.P. Morgan Investment Management Inc.

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Copyright 2018 JPMorgan Chase & Co. All rights reserved.


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