The repercussions of trade wars

Trade, in various forms, has always played a role in life. Over time, trade evolved and expanded especially with the introduction of money as a medium of exchange, the development of more efficient and reliable modes of transport as well as increasing demand for goods and services on the back of an expanding population in a globalised world.

In more recent history, countries around the world recognised the importance of trade with the setting up of the World Trade Organisation (WTO). Its origins date back to the late 1940’s following the ramifications of World War II. The WTO currently comprises 164 countries. The goal of the WTO is to “ensure that trade flows as smoothly, predictably and freely as possible” in line with the belief that apart from the economic benefits that could be derived from trade, a well-functioning global trade system could also contribute to international peace.

Nonetheless, international trade has been faced with numerous challenges even in recent decades as countries and their respective leaders seek to justifiably or unjustifiably protect their own economy. Protectionist measures can take various forms including import tariffs, import quotas, domestic subsidies and administrative barriers. Naturally, such measures are not well-received by the counterparty which generally tends to retaliate with protectionist measures of its own. Such actions could escalate as one party continues to retaliate against the other spiralling into a trade war which in turn has negative economic implications for both parties as trade wars create uncertainty and potentially economic hardships if prolonged.

Protectionist policy and its ensuing retaliations has recently become a source of much discussion and debate as the US President Donald J. Trump imposed various tariffs on a wide range of items being imported in the US from a number of countries including China, Canada, Mexico and the EU. Some of the measures included an additional 25% tariff on steel and 10% on aluminium imported from the EU, China and Mexico as well as a 25% import tariff on USD50 billion worth of Chinese goods. Such countries retaliated by imposing tariffs on imported goods from the US. As an example, the EU applied tariffs across three major sectors, US imported steel, industrial as well as agricultural goods. The scope of such retaliation was to send a strong political message by targeting symbolic American items.

Furthermore, the EU, China and Canada have lodged their complaints before the WTO claiming that the imposed tariffs are inconsistent with existing trade agreements.

One of the main aims of the trade barriers being imposed by the US is to address the country’s large trade deficit, a situation where the level of imports is significantly higher than its exports. This results in a higher amount of US Dollar flowing out of the country compared to the amount of foreign currency entering the US. The large trade deficit has been heavily criticised by President Trump who reiterated his views and started taking action ahead of the mid-term elections to be held in the US in November 2018. As such, the measures imposed by the US have been implemented as promised in a bid to reduce this trade deficit which reached USD566 billion in 2017. However, it is important to note that President Trump implemented such protectionist measures on the premise of safeguarding national security. In fact, in contrast to previous US Presidencies during which tariffs were imposed, President Trump has significant discretionary legislative powers to impose, escalate or remove such tariffs.

As evidenced in recent months and weeks, the implications on financial markets are wide-ranging. Although it is very difficult to discern the direct consequences of trade wars given the variety of factors that affect today’s globalised economies and financial markets, trade wars have definitely contributed to the volatility across financial markets evidenced during recent months given the uncertainty that they produce. The adverse implications of a trade war were excellently captured in an article published on 21 June 2018 by ‘The Economist’ under the heading ‘Battle lines drawn’, in which the journal notes that “Whatever form this conflict takes, and however long it lasts, there will be no winner.”

Naturally, currencies are heavily influenced by trade given that goods and services are exchanged for money. After the initial announcements by President Trump revealing his intentions on trade tariffs, the US Dollar weakened somewhat against the respective currencies of the countries against which the tariffs were imposed. On the other hand, as the tariffs were implemented, the US Dollar rebounded possibly in view of the demand for safe-haven assets amid growing uncertainty. Nonetheless, other factors such as escalating political risk across the eurozone, also played a part in the aforementioned US Dollar rebound against the euro.

The trade war between the US and other major countries is also likely to impact economic growth. The US had been registering substantial economic progress which also led the US Federal Reserve to hike its benchmark interest rate by 175 basis points (25 basis points in each of 2015 and 2016; 75 basis points in 2017 and a further 50 basis points in the first half of 2018). Meanwhile, the eurozone is lagging the US in terms of economic growth which in turn has led to further delays in rate hikes by the European Central Bank (ECB).

Despite this divergent growth path for gross domestic product (GDP), both the Federal Reserve and the European Central Bank have indicated material downside risk following their respective latest monetary policy meetings. The Federal Reserve noted that until now its projections do not include any impact from the trade war, but it still poses downside risks to the future economic prospects of the US. Meanwhile, the ECB has already evidenced some economic weakening whilst also noting that rising tensions could erode confidence to an extent that is difficult to gauge at this point in time.

Similarly, the European Commission reduced its 2018 real GDP forecasts by around 0.2 percentage points given the initial adverse effects of the trade war. Nonetheless, the European Commission clearly warned that its forecasts are subject to significant downside risks as they do not account for any escalation of measures. Such risks could materialise in the coming months as the US prepares to launch other tariffs on an additional USD200 billion worth of Chinese imports, which could be raised to USD500 billion following recent statements by the US President. Recently, the International Monetary Fund (IMF) noted that although it kept its global growth forecast unchanged, the escalating trade tensions are threatening to derail a global upswing that is already losing momentum. Moreover, the IMF warned that financial markets seem complacent to such downside risks.

Other potential adverse impacts of a trade war include the unintended rise in inflation as imports are more costly. In turn, this could limit the effectiveness of monetary policy tools in counteracting any economic downturn since loosening monetary policy (in a bid to support economic activity) should also lead to higher inflation. Therefore, a central bank facing a situation of declining economic activity but rising inflation would need to strike a balance between expanding monetary policy whilst keep inflationary pressures in check.

From an investment perspective, investors should also be aware of the direct consequences that protectionist measures have on specific industries as well as individual companies. US steel producers may benefit from the protection provided by import tariffs on steel, at least in the short-term, but on the other hand, in view of the retaliatory measures implemented by the trade partners of the US, North American exporters may suffer.

Although it is very difficult to predict whether the US will manage to effectively lower its trade deficit or for how long this trade war will prolong, it can be safely assumed that volatility will continue to be a prominent feature across financial markets in view of the uncertainty and geopolitical tensions being created. Furthermore, if the trade war persists and escalates even further, it can have unquantifiable adverse effects on economic growth as well as on the performance of individual companies across the globe.

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