A New Era of Trading Blows

Occasionally there are moments that trigger a significant shift, or reinforce existing fears. One of these may have occurred on Friday. Time will tell. President Trump’s decision to initiate trade sanctions against Mexico, and the threat to escalate them further, was unexpected.

The move appeared to catch even some of his senior team unawares. This includes Vice President Mike Pence and Chief Trade Negotiator Robert Lighthizer. On Friday they were, respectively, in Canada and the US Congress, promoting the US Mexico Canada Agreement (USMCA), which is the planned new trade agreement to replace NAFTA. Previously, the US administration had expressed a desire for USMCA to be ratified by all concerned by the end of the summer. This is now unclear or unlikely.

President Trump announced a planned 5% tariff on Mexican imports to take effect on June 10th, and to be increased by 5% each month to 25%, unless Mexico halted illegal immigration. A possible trigger appears to have been footage of a large number of illegal migrants crossing the border. While that may have been the political trigger, for the markets the concern was that Friday’s announcement suggested a lack of policy coordination and that the US now appears to be fighting a trade war on two fronts: versus China and against Mexico.

Hopes that some order had returned to the world

In the fourth quarter of last year, global markets were turbulent against the backdrop of a deterioration in trade tensions between the US and China. It was feared that an escalating trade dispute would knock growth in both countries, and have wider contagion. In October, the IMF cut global growth forecasts at their spring meetings. At that time, markets were also worried about monetary policy tightening across the globe, led by the US. Thus, equities suffered, and fixed income assets outperformed.

During the first few months of this year, this situation reversed. Equities rallied. Bond yields rose, albeit slightly. Two factors largely accounted for this. One was the reversal in monetary policy. Previous tightening – that had been factored in – was ruled out, and led by the US, monetary policy now looked set to be on hold, with a bias to ease if needed. The second appeared to be progress on the trade dispute between the US and China.

In particular, moving into the second quarter of this year, the news from the US and China was of ten rounds of relatively successful trade negotiations. Economic indicators appeared to stabilise, and in the US, Western Europe and Japan, labour market conditions appeared solid, with employment up and wage growth rising. Meanwhile, global inflation pressures appeared to ease. China, too, relaxed policy.

While the world economy had slowed from last autumn and into this year, it was expected to stabilise, helped by policy accommodation and a de-escalation of trade tensions. In fact, there was a perception the US-China trade dispute was part of a wider jockeying of position between the two powers. A bilateral meeting on the side-lines of the G20 in Japan in late June was outlined, adding to expectations that the trade dispute might not continue to fester. But in recent weeks, progress halted and the dispute widened to cover the issue of access to technology.

Now fears that stability may be dashed – on two fronts

Now, however, we are contending not only with a deterioration in the US and China trade dispute but also an escalation with Mexico. The latter not only would dampen growth prospects in both economies, but also has reduced expectations that the US and China dispute will be resolved any time soon. Indeed, if President Trump perceives this to be popular with his supporters the US position could become more entrenched.

Over the weekend, China released their new policy White Paper on the trade dispute. Also, on Saturday, China raised tariffs on US imports where tariffs were already in place. The Chinese also stated that nothing is agreed, until everything is agreed. In Singapore, meanwhile, at an annual global defence conference, the Chinese Defence Minister indicated, too, that China will not back down on the trade dispute.

The direct effect is to dampen demand and growth expectations.

The US perspective

Let’s look at this from the US perspective: higher tariffs are a tax on US consumers. If it is not possible to divert demand immediately then consumers pay higher prices, or importers’ profit margins are squeezed, or both.

Much depends on whether there can be a substitution towards production at home in the US, or from other countries not impacted by the tariffs and thus where prices would be lower than on the goods hit by tariffs. In reality there could therefore be a displacement effect, in the sense that producers and consumers may switch demand to goods not impacted by higher tariffs.

For instance, last year the IMF reported that Mexican goods had substituted for Chinese goods, with US imports from Mexico up, as those from China fell. Likewise, Brazilian soya bean exports to China rose, as US soya bean exports fell, as tariffs were imposed.

Economic models tend to also factor in other indirect effects, such as rising uncertainty dampening investment, increased financial stress having wider negative economy-wide effects, and also some dampening impact on productivity. Markets may also fear an escalation of the situation. This is now a particular concern, in view of the unexpected intensification with Mexico.

Global growth could fall, disputes could escalate

Confidence about future economic growth will also be likely affected, globally and in those economies directly impacted by the disputes, namely US, Mexico and China. Previously the IMF had talked of global growth in 2019 falling from the 3.5% they expected before to 3.3% because of tariffs. They could cut this growth expectation further.

There may also be a fear that the current disputes will escalate and that the imposition of higher tariffs could widen to other countries or products, and that international supply chains will start to be disrupted. President Trump, presumably, hopes this results in a reshoring of some production – from China or Mexico to the US, benefitting jobs.

Markets, meanwhile, will worry that if supply chains are disrupted then this will dampen trade and investment plans, and hit business confidence. Global growth would be expected to suffer and we should expect to see a downward revision to growth expectations if there is no early resolution.

Recent trends likely to be reinforced

Markets, as we know, can over-react, but this will likely reinforce recent trends: with safe havens favoured. Meanwhile, it will reinforce the expectation that monetary policy will be accommodative, and even looser.

In recent weeks a number of central banks, including a number in Asia, have cut interest rates. This week, in addition, Australia is expected to cut rates and over the coming weekend G20 Finance Ministers and Central Bank Governors will meet in Japan.

Market attention will, naturally, be on the US and the Fed in coming weeks, but they are unlikely to want to signal any easing. Instead, they may confirm policy is on hold. The hope will be that as this trade situation deteriorated rapidly and unexpectedly, it can be resolved just as quickly, but the longer the current state of play continues, then the more it will dampen growth prospects.

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