“Patriotism, jobs and trade” is the pithy expression that best encompasses President Trump's economic priorities. Similarly, his guiding principle on policy formation can be best expressed by the rather straightforward question: Is it friendly to U.S. businesses?
By bringing this pro-business perspective into the executive branch, the November election was clearly a real game changer, and one that has elicited an understandably positive reaction from markets. However, in our view, many investors have been overly focused on the potential positives that Mr. Trump's policies could bring-tax reform, deregulation, and increased spending on infrastructure-while paying scant attention to the potential negatives-trade protectionism and the pressure that higher interest rates could exert on equity valuations.
Protectionist sentiment is mounting
A little over a month into the Trump administration, its initial actions and statements suggest to us that the president and the trade team that he is assembling embrace acutely protectionist views, particularly in regard to China. Although Mr. Trump's policies on some issues may appear fluid and tactical, his views on trade have been remarkably consistent. In fact, he has been calling for protectionist measures for at least the last three decades, back to 1987, when he used $100,000 of his own money to take out full-page ads in the New York Times, Washington Post, and Boston Globe attacking U.S. trade policy and demanding significant tariffs on Japan and “other nations that have been taking advantage of the U.S.”
More recently, Mr. Trump has viewed China as the great offender, believing its mercantilist approach is embedded into its economic system at a fundamental and profound level. While some of his campaign rhetoric was extreme, his threat to levy a punitive 45% tariff on goods imported from China (35% from Mexico) should be taken seriously. This proposal is an integral feature of his plan to “bring back our jobs from China, from Mexico, from Japan, from so many places.” This attitude extends beyond the White House, as Washington, D.C., currently appears to be overflowing with China critics in Congress and in conservative think tanks, leading us to conclude that China-bashing is likely to emerge as one of the few bipartisan initiatives this year.
How likely is a global trade war?
We believe an acceleration of tit-for-tat protectionist measures is one of the biggest risks to global markets over the next couple of years. We see three possible scenarios for 2017–2018:
1) Status quo: Mr. Trump focuses on other issues, such as tax reform and repealing the Affordable Care Act, or China preemptively lowers some tariffs, so no major protectionist actions are taken. We estimate a 15% likelihood of this scenario playing out.
2) Moderate trade frictions: Mr. Trump maintains his strong rhetoric, but merely imposes selective, largely symbolic tariffs on high-profile imports, such as steel and aluminum. China adopts reciprocal, token actions. This scenario would resemble the U.S.–Japanese dispute in the 1980s, during which retaliation remained controlled and restrained, causing only minor hiccups. We estimate the probability of this scenario at 60%.
3) Full trade war: Mr. Trump's trade team delivers on its aggressive promises-for example, by imposing tariffs of 35% to 45% on a wide range of imports-with China retaliating immediately and forcefully. Measures escalate, calmer voices do not prevail, and a full trade war ensues. We estimate a 25% chance of this scenario playing out.
Aside from protectionist actions against China, it is also possible that Mr. Trump unilaterally imposes tariffs of up to 35% against Mexico.
Likely impact of a trade war on the U.S. economy
The most meaningful study we have seen on this topic was undertaken by the Peterson Institute, a Washington, D.C.-based research firm that is highly regarded for its analysis of trade and globalization. Its study presents a baseline case for the growth of the U.S. economy, as well as two scenarios:
1) Aborted trade war: The United States imposes tariffs, but for only one year, as an agreement is quickly reached or Trump's trade team hastily backs down.
2) Full trade war: The United States imposes a 45% tariff on imports from China and 35% on Mexico. Those nations respond in kind, resulting in a dramatic negative impact to economic activity, including a cumulative 3% hit to U.S. consumption and a 9% hit to capital spending by 2019.
In the event of either an aborted trade war of a full trade war, it seems reasonable to expect that the sectors of the U.S. economy with the greatest foreign exposure would be hit the hardest. The most vulnerable sectors are information technology, materials, industrials, consumer staples, and consumer discretionary. Disruption could be significant for many businesses, given the increasingly complexity of global supply chains.
Are markets prepared for the likelihood of trade spats?
We believe the short answer is no. To illustrate, global economic policy uncertainty was recently at the highest level experienced since the 1997 inception of the Global Economy Policy Uncertainty Index. At the same time, U.S. equity market volatility was recently near a 10-year low, as measured by the CBOE Volatility Index. This suggests a high degree of complacency and a lot of room for investors to be disappointed in the second half of 2017.
Although we are moderately constructive on the outlook for equities, we expect that it will prove more challenging than the optimists envision for the Trump administration to deliver what the market expects. Further, we believe the market continues to pay insufficient attention to the risks of protectionism. As a result, our base case for equities in 2017 anticipates gains in the high single digits in percentage terms, but with more uncertainty and a wider range of potential outcomes than normal.
The Global Economic Policy Uncertainty Index is a GDP-weighted average of national economic policy uncertainty indexes for 18 countries: Australia, Brazil, Canada, Chile, China, France, Germany, India, Ireland, Italy, Japan, the Netherlands, Russia, South Korea, Spain, Sweden, the United Kingdom, and the United States. Each monthly national economic policy uncertainty index value is proportional to the share of own-country newspaper articles that discuss economic policy uncertainty in that month. The CBOE Volatility Index (VIX) projects the probable range of movement in the U.S. equity market by measuring the implied volatility of the S&P 500 Index for the next 30 days. The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. It is not possible to invest directly in an index.
Stocks can decline due to adverse issuer, market, regulatory, or economic developments, and the securities of small companies are subject to higher volatility than those of larger, more established companies. Foreign investing, especially in emerging markets, has additional risks, such as currency and market volatility and political and social instability, and illiquid securities may be difficult to sell at a price approximating their value. Hedging and other strategic transactions may increase volatility and result in losses if not successful. Fund distributions generally depend on income from underlying investments and may vary or cease altogether in the future.