This environment has even long-term investors looking for places to hide as a tariff-driven world economy is too difficult and potentially painful to contemplate.
While the Trump administration’s rhetoric on trade is becoming problematic, especially coming so soon after the disastrous G7 meeting in Quebec, I would urge investors to remain calm. We have dealt with other equally problematic situations with equally ground-shaking potential outcomes for the global economy in this cycle. And the cycle has continued. Despite the inherent unpredictability of the protagonists in this drama, I still believe that this is likely to be the case for this episode as well.
First, do you remember President Trump’s famous “fire and fury” language that warned Kim Jong Un of the consequences of acting on his threats? Fast forward to the Singapore summit, complete with pictures of a denuclearization of the Korean peninsula in hand and the two principals virtually hugging each other. The rhetoric of fire and fury raining down on North Korea was a negotiating tactic, nothing more.
In this case, we have replaced fire-and-fury rhetoric with trade-and-tariff rhetoric, but the goal is likely the same. It’s an effort to get to a deal.
Well, because the one economy in the world that has the most to lose from a trade war is the U.S. And given the ever-present fragility of the global economy due to structural reasons, post-financial crisis, the damage to the U.S. economy would be even more severe in the long run. In other words, by acting on these trade threats, the U.S. would be shooting itself in the foot. I, for one, am reluctant to create long-term investment portfolios based on expectations of countries and institutions committing self-harm. That is just not prudent.
The reason the U.S. has the most to lose from a slowdown in global trade, whether through a trade war or tariffs, is because we are the most saving-short economy in the world and need to import global savings to sustain our fiscal deficits. Until that changes, no amount of tariffs will reduce the trade deficit. Tariffs will simply allocate rents from one part of the economy to another, and imports from one country to another, without significantly changing the terms of trade for the U.S.
Further, let’s assume the worst for a second, that roughly 10% across-the-board tariffs are imposed on all of roughly $500 billion of imports from China. Ignoring the multipliers and other fancy math, we are talking about $50 billion in effective tax on a very large U.S. economy. Yes it is a large number, but it is not a catastrophically large number. Under these circumstances, the U.S. economy will still do well.
Because of the price elasticity of export demands, Chinese growth will of course slow down, but there too the impact is likely to be modest at worst. Further, to protect its domestic economy, the likely policy outcome in China will be another round of easing and another down leg in the yuan to act as shock absorbers. Neither of these are good long-term outcomes, but they are not that bad in the short run.
Market sentiment, on the other hand, could be hurt in the short term. But one of the things that we have learned in this cycle is that a drawdown on market sentiment won’t kill the cycle as long as monetary policy support remains in place, which I firmly believe will be the case. As a worst-case scenario, in my view, the scenario outlined above is bad, but not catastrophically bad.
Even if the situation worsens and we get into a global tariff conflict, economists with sophisticated models estimate an impact on the global economy to the tune of a couple of percentage points of growth. This would certainly be a very bad outcome, but still not a catastrophically bad outcome. And that is the true worst-case scenario.
Tariffs may certainly lead to drawdowns in the market, but they will not kill the cycle.
From a longer-term perspective, I continue to believe that the biggest reason to stick with the current cycle for nominal assets is the continuing level of monetary support. As long as the developed market central banks remain supportive – which they still are, despite the U.S. Federal Reserve’s past tightening and the European Central Bank getting closer to that phase – the cycle will continue.
I am not getting too caught up in the tariff brouhaha, as I believe it is in everyone’s interest – especially the U.S.– to find a resolution, even if it is after a lot of political posturing. I suggest you don’t get too caught up, either.