Equity markets have been knocked down by the escalation of trade tensions between the US and China with global equities now some 3-4% off their recent highs. The correction is not a big surprise as hopes of a trade deal were a major factor behind the 15% gain racked up this year before the latest sell-off.
On Friday, the US carried out its threat to raise the tariff on $200bn of Chinese imports to 25% from 10%. It is also threatening to impose a 25% tariff on a further $300bn of goods, which would leave almost all Chinese imports subject to a tariff, although this wouldn’t be implemented for a couple of months. China has yet to announce any retaliation but may well do so over coming days.
Our base case remains that some kind of trade deal will be reached eventually because ultimately it is in the best interests of both sides to do so. That said, we acknowledge the risk of negotiations breaking down altogether and the US imposing tariffs on the remaining $300bn of Chinese imports has clearly risen significantly. There is a danger of miscalculation with Trump overplaying his hand and the Chinese being unwilling to lose face and accommodate his demands.
Somewhat surprisingly, the direct impact on economic growth of these tariff increases – even if they all went ahead – should not be that large. Rather, the main risk lies in the indirect effects on growth stemming from the hit to business confidence and likely sell-off in equity markets. These would very likely exceed the total direct impact. On top of that, global growth is only now starting to bottom out and is not that well placed to withstand a new hit from a trade war.
The good news, however, is that the US Fed looks much more willing to respond to a weakening in growth by cutting interest rates than it did a few months ago. Although we could well see a major escalation of the trade dispute pushing equity markets down another 5-10%, a more supportive Fed is expected to prevent them retesting their December lows.
Either way, we expect continued market volatility as the US-China trade battle plays out. As discussed in recent reports, we have been planning to scale back somewhat our underweight of equities and will be looking to take advantage of any further market weakness to do exactly that.