Financial markets have experienced another bout of volatility, this time related to an escalation in protectionism involving the US and China. An escalation of such tensions towards a full-blown trade war would be very damaging for global growth and certainly for global financial markets. We therefore describe two risk scenarios associated with such an escalation and present a road map to navigate them.
Protectionism: a reversal of globalisation?
Globalisation – the increasingly free movement of goods, services, labour and capital – has been a key driver of increased prosperity around the world. However, not all have benefited from this process and some governments, notably that of the US, have started to address trade imbalances as a way to support their dissatisfied electorates.
To what extent can globalisation be undone?
A significant reversal in the globalisation pendulum would be very damaging for global growth and for financial markets. But it is still unclear how far back the pendulum will swing as there are institutional hurdles – such as the US Congress, the World Trade Organization (WTO) and financial markets themselves – that may slow down, limit or even stop the current initiatives by the Trump Administration.
We envisage two possible escalation scenarios
The first is a multilateral trade war, between the US and the rest of the world. The second is a bilateral trade conflict, between the US and China. In both cases we envisage a prolonged period of tension. Crucially, we still see the risks of full-blown trade wars as low probability-high impact scenarios.
What is important for investors is how to navigate an escalation or de-escalation of those risk scenarios. For instance, these situations could escalate rapidly leading to sudden market moves as investors quickly reassess the probability of a trade war.
Alternatively, the risks could escalate in steps, for example, if markets perceive that trade tensions may lead to tit-for-tat retaliation. We therefore provide certain signposts that should help investors assess potential shifts in markets as protectionism evolves.
In our analysis we also delineate the likely economic impact of trade wars. The combination of tariffs and quotas and the reversal of the globalisation of production and supply chains would likely lead to higher prices, lower productivity, and ultimately lower output. We also examine the likely response of central banks including how they view possible second-round- effects such as workers pushing for higher wages and higher inflation expectations.
We also gauge the asset price implications of trade wars. We look at financial markets’ responses to oil shocks (used as proxies for supply shocks) as well as recent episodes of protectionist escalation.
We conclude that equities are the asset class at most risk. The performance of other asset classes is usually mixed, suggesting that the macroeconomic and policy backdrops matter in terms of shaping markets’ responses.
No change in our strategy for the moment…
As for strategy, we are not altering our base case scenario of strong growth and contained inflation. But while we may believe that the probability of full-blown trade wars is still low (below 10%), we do expect further outbreaks of protectionist tension as the globalisation pendulum continues to oscillate back and forth, and that makes the trading environment riskier.
With higher uncertainty or ‘fatter tails’, market volatility and risk premia should move higher. If the trade war scenarios remain at a low probability, it makes sense to hedge portfolios against them with assets that do well in risk-off situations but that do not underperform if these risks fail to materialise.
Click here to read a full version of the report “A road map for navigating protectionism: The elevator and the staircase”
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