By Kevin Muir
Quick – the United States suddenly backtracks on half century of globalization and enters a trade war with almost all of its trading partners – do you buy or sell equities? And how about bonds?
Don’t mistake this question as me going full tinfoil-hat – I know we are far from a trade war – but it is an interesting exercise to contemplate.
I don’t have an answer how a trade war would affect financial markets. The reality is that “it depends”. I know, I know – the old joke about the one-handed economist is probably applicable here, but the financial repercussions from a trade war are not as obvious as they might seem at first.
Trade wars cause rising prices – no denying that point. But whether that causes stock and bond prices to rise or fall depends a lot on the reaction function of the central bank.
By now most are familiar with the Trump administration’s recent actions regarding steel and aluminum tariffs. No need to rehash the developments. Nor am I passing moral judgment on their fairness. The United States has the right to pass whatever trade laws it deems fit. Though, I must admit, couching the tariff on “security concerns” is stretching it a little. Can’t say I disagree with Canada’s Prime Minister’s response (from The Hill):
“Let me be clear: These tariffs are totally unacceptable,” Trudeau said. “Canadians have served alongside Americans in two world wars and in Korea. From the beaches of Normandy to the mountains of Afghanistan, we have fought and died together.”
Noting that Canada purchases more U.S. steel than any other nation, Trudeau lambasted the Trump administration for initiating the tariffs under the guise of confronting a threat to national security. “Canada is a secure supplier of aluminum and steel to the U.S. defense industry, putting aluminum in American planes and steel in American tanks,” Trudeau said. “That Canada could be considered a national security threat to the United States is inconceivable.”
“These tariffs are an affront to the long-standing security partnership between Canada and the United States, and in particular, to the thousands of Canadians who have fought and died alongside American comrades-in-arms,” he finished.
But instead of getting all indignant, I would simply state the United States is “not that into” trade these days, and other nations should accept it and adapt.
The United States is becoming more protectionist. Full stop. Look at the individuals Trump is putting in charge of trade. That’s all you need to know.
Instead of arguing about whether these policies are right or wrong, let’s instead examine what they might mean for financial markets.
As I mentioned, trade protectionism causes higher prices. There is no disputing that fact. The only question is whether the central bank monetizes those increases and causes inflation, or whether the tariffs have the effect of causing a decrease in economic production as a less optimal economic solution is reached.
If the central bank was truly interested in preserving the long-run value of money, then an increase in tariffs would be met with an increase in interest rates. So that begs the question of whether the Federal Reserve will view these tariffs as a development that calls for higher interest rates.
And here is where it gets tricky. We won’t know what the Federal Reserve would have done absent these tariffs.
But at the risk of making a fool of myself, here is my thinking regarding the path of rate hikes. Powell will keep the Federal Reserve on a course of hiking every other meeting until something breaks. He won’t deviate from this schedule until there is a dramatic change in either the economic or financial landscape. If I am correct, then Trump’s tariffs will have no effect on monetary policy. Thus, given the no change in monetary policy, at the margin, Trump’s tariffs will be inflationary.
Back to the question I started the post with. Under the current circumstances, I would probably buy equities and sell bonds.
However, this is assuming that the United States is able to control the situation. Trump has taken the U.S. down a road where it is them against the world.
What if this results with the rest of the world viewing the behaviour as proof that the United States is not reliable?
Don’t forget that Trump is upset about trade deficits. That metric is really stuck in his craw. Yet, the nation with the reserve currency, almost by definition, runs trade deficits.
Therefore if Trump is insistent on eliminating all of America’s trade deficits through protectionist trade policies, he is hastening the abandonment of the US greenback as the world’s reserve currency. This will mean a lower level for the US dollar.
Over the past couple of months, the US dollar index has rallied from the severely oversold level of 90 all the way up to 95 a couple of days ago.
It makes sense to once again start leaning short against the US dollar. I know this seems counter-intuitive to all the worries filling financial media about Europe and emerging markets, but sometimes the best sales are those in which you are most alone.
All of my ramblings are based on the idea markets do not get spooked by Trump’s protectionist moves. So far, that’s spot on correct. Yet it’s a little surprising that the threat of a trade war has not caused even the slightest bit of concern. The markets have been lulled into believing that Trump’s moves are just negotiating tactics that will be quickly reversed in the coming weeks.
But a little part of me is worried that markets are overlooking some really negative developments. Sure, maybe Trump will backtrack on these policies just as quickly as he entered into them. But what if he doesn’t?
As the BBC reported, US officials are playing with fire:
The US is playing a “dangerous game” by slapping tariffs on European steel and aluminium, the European Union’s trade commissioner has said.
Cecilia Malmstrom warned the move by US President Donald Trump would have consequences for the economic recovery of the EU, as well as US consumers.
The EU has issued a 10-page list of tariffs on US goods ranging from Harley-Davidson motorcycles to bourbon.
Canada and Mexico are also planning retaliatory moves against the tariffs.
Ms Malmstrom said the EU would challenge the move at the World Trade Organization (WTO) but that tariffs on US imports were necessary as “we cannot just take these tariffs and stay silent”.
The commissioner said that despite the EU’s “rebalancing” action, the two sides were not in a trade war.
“What we are in is a very difficult situation,” Ms Malmstrom said. This situation could only be defused by the US withdrawing its measures against the EU, she added.
And the analogies to another historic period in history are not lost on everyone. From today’s FT:
The Republican senator, Ben Sasse, put it best: “‘Make America Great Again’ shouldn’t be ‘Make America 1929 Again’.”
Most of the world, including the majority of America’s business community, see Donald Trump’s punitive trade actions in a similar light. They are searching for economic logic where none exists. His impulse is political. Though slapping tariffs on metals and car imports will lead to a net loss of American jobs, Mr Trump’s actions are meant for the “forgotten American”. They will feel noticed, even if it costs them dearly.
The biggest price tag is geopolitical. Mr Trump’s decision to impose the tariffs on national security grounds was simply a matter of convenience. The notorious section 232 of the Trade Expansion Act has only been used twice before – each time with some justification. Mr Trump is barely trying to make the national security case against European or Canadian metal imports. He chose 232 because the law gives the US president maximum leeway to do what he likes.
He is using the same law to justify impending punitive duties on foreign car imports. But what goes round may come round. Having broken a cardinal rule of transatlantic trade relations, Mr Trump will not be able to unbreak it. He is replacing a system of rules with political whim. The correct free trade answer would be for Europe to offer no response at all. But the European Union, which has a list of retaliatory targets, including Harley-Davidsons, Bourbon and jeans, is politically obliged to retaliate. Brussels will also take the US to the World Trade Organization’s disputes resolution court.
Launching a simultaneous trade war against America’s allies and adversaries conforms to no known international rules of logic. It will raise domestic prices, cut US jobs and reduce America’s global influence. Warning that Mr Trump’s actions could break the WTO will also fall on deaf ears. That may well be an outcome that Mr Trump desires. His chief trade negotiator, Robert Lighthizer, has long nursed a grievance against the global body. Mr Trump rails frequently against unelected American judges. He could doubtless win more retweets with a tirade against unelected foreign judges.
America’s trading partners are learning how to read Mr Trump the hard way. The US president is committed to the pursuit of a trade war of all against all. Drawing parallels to the 1930s, Emmanuel Macron, France’s president, warned this week of “modern-day sleepwalkers”. But that is a poor metaphor. Mr Trump knows exactly what he is doing. The fact that it poses a threat to the global order is a feature, not a bug, of his actions.
If Trump can navigate these trade negotiations anywhere near as adeptly as he believes in his own mind, then maybe the financial markets are reacting perfectly to these developments. Yet maybe it’s one of those times when it doesn’t matter until it matters (and then it matters a whole lot!)
Have a great weekend,
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