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Beyond Borders and Bilateralism: The Import of Trade

by Chris Bailey, European Strategist, Raymond James Investment Services

There is no word more dangerous (in finance) than ‘extrapolation’ and anyone but the most neophyte of investors has grown up with a backdrop of progressively liberal global trade rules. The General Agreement on Tariffs and Trades (GATT) in 1947 led to the creation of the World Trade Organisation (WTO) in 1995. The WTO, which boasts a membership of 164 countries, may now preside over services and intellectual property, as well as more traditional manufactured goods, but new challenges have arisen in recent quarters. The threat of trade wars typically tops any investor’s list of current global risks.

Cooperation is crucial

Any fledgling economics student knows economic growth is made up of consumption, investment, government spending, and a net trade (exports minus imports) contribution. Trade angst that leads to less interaction between economies, in most circumstances, leads statically to lower economic growth as supply chains are interrupted and more expensive alternatives are less cost-efficient. A few studies in recent months have attempted to quantify the impact of new tariff actions from countries such as the U.S. and China. These studies have suggested an economic growth level reduction of around 0.3% in 2020 for both the U.S. and the pan-European economy compared to the previous status quo of no new tariff implementation. The suggested negative impact on Chinese economic growth levels is a little higher at over 0.5%, but in the wider scheme of things, this is a nudging down of economic growth rates, not an immediate precursor to economic recession.

Trade policy, however, tends not to have quantifiable, static effects on its own. The lengthy period of progressive trade liberalisation following World War II led to an increasingly complex and inter-related global economy which benefited from the application of the law of comparative advantage. And as is the nature of economic systems leaning towards capitalism, the incentives and informational insights created from the positive benefits of trade create new and dynamic benefits that allow economic growth to advance further. Unfortunately, any regression in such trends threatens a negative reversal in this mirror image of trade. And the transmission mechanism for this? Retaliatory tariffs.

Pyrrhic Probabilities

Any student of world trade trends over time knows that the ‘titfor-tat’ retaliatory tariff measures, apparent during much of the 1930s, both deepened and prolonged the economic depression at that time. Certainly, such insights from economic history remain highly applicable to today’s global economy and may actually occur more quickly and more powerfully due to higher levels of trade, interdependence, and integrated supply chains. Such outcomes bode particularly poorly for economies that have placed emphasis on export success and typically being important parts of the global supply chains for corporations and governments around the world. The three best examples of this today are China, Germany, and Japan.

Starting with China, global investors became accustomed to the Middle Kingdom dominating at-the-margin consumption growth statistics. With an urbanising and wealthier population of over one billion, this should not be surprising; however much of the heavy lifting in the thematic development of the Chinese economy over the past generation has been undertaken by its ever-stronger capability as a producer of intermediate goods for export. China may no longer be the cheapest country to manufacture many goods, but a sharp slowdown in the country’s exports due to trade war angst threatens much more than just a reduction in the country’s economic growth level. In a static sense, slower economic growth rates can be offset by more stimulus efforts and this has been apparent over the past few months with a loosening in both monetary and fiscal policy, which has helped keep headline economic growth rates close to quoted targets. However, such a focus threatens progress with the country’s all-critical domestic reform and change programme, which is attempting to improve the efficiency, dynamism, and longer-term growth potential of the Chinese economy by reforming the banking sector and reducing excesses in areas such as local government debt levels and an over-reliance on the property sector. With the maintenance of stability (and no need to worry about re-election), an overriding objective of the Chinese government, a risky but politically nationalistic dynamic push back, would be a continuation of recent policy of tariff and technological ‘tit-for-tat’ retaliation. This, however, would slow Chinese economic growth with implications for every country or company selling into the country while inducing material friction into the global trade and diplomatic backdrop, which is why the recent talks in Osaka were quite conciliatory.

Another policy option would be to let the Chinese yuan depreciate to help offset higher tariffs and boost price competitiveness at the margin. Currencies, over recent months, have certainly heightened trade tensions, but recent shifts feel more like a reaction to world trade concerns. Any progress in the world trade backdrop is likely to lead to a lower value of the dollar which should help reduce inflamed trade tensions.

The German Question

One area that would be negatively impacted by many of the issues noted above is Europe, Germany in particular, the region’s largest economy, whose economic growth has also been assisted over the last couple of generations by export success, especially in a variety of automotive and industrial sectors. Thus far, global trade angst has been focused on the bilateral relationship between the U.S. and China; however, these developments have both static and dynamic risks for all European economies, particularly Germany.

The static implications can already be seen with recent German economic growth levels being closer to those of the struggling Italian economy than those of other leading European economies such as France and Spain. To date, however, there has been little dynamic impact apart from a slight softening in demand from China.

Stress Testing Alliances

In a scenario of ‘tit-for-tat’ and retaliation between the U.S. and China, Europe will not be able to stand aside. Already, discussions concerning issues around WTO decision-making and dispute resolution have thrown up divisions, particularly between Europe and the U.S., supplementing some early-stage trade disputes between the two regions. Simultaneously, the European Union leadership, supported by Chancellor Merkel of Germany, has criticised the actions of the populist Italian government in overtly supporting the Chinese ‘Belt and Road’ initiative. More trade frictions create further pressures and incentives for Europe to choose a side, or face new tariffs or sanctions from everyone else. Certainly it was fascinating to see at the recent Osaka conference the lack of pan G-20 cooperation apparent in the summary communiqué published.

By contrast, Japanese relations with the U.S. have remained more cordial, despite the potential for trade related disputes in areas such as the automotive sector. The reason for this may be linked to the relatively close defence relationship between the two countries, along with Japan’s instinctive regional caution toward China. Recent manufacturing sector data in the country has shown an impact from the worsening global trade backdrop, at a time when Japanese domestic economic growth dynamism remains muted (as reflected by continued use of quantitative easing policy).

DISCLAIMER: The information contained in this article is for general consideration only and any opinion or forecast reflects the judgment of the Research Department of Raymond James & Associates, Inc. as at the date of issue and is subject to change without notice. Past performance is not a reliable indicator of future results.

You should not take, or refrain from taking, action based on its content and no part of this article should be relied upon or construed as any form of advice or personal recommendation. The research and analysis in this article have been procured, and may have been acted upon, by Raymond James and connected companies for their own purposes, and the results are being made available to you on this understanding.

Neither Raymond James nor any connected company accepts responsibility for any direct or indirect or consequential loss suffered by you or any other person as a result of your acting, or deciding not to act, in reliance upon such research and analysis. If you are unsure or need clarity upon any of the information covered in this article, please contact your wealth manager.