Trade Policy Risks: Deploying Uncertainty

Lately with trade disputes ratcheting up, I’ve had a lot of questions about the impact of trade uncertainty on market actors and businesses, including whether markets are overpricing risks given the strength of global growth. The jury’s still out, particularly as we’ve been in an as good as it gets moment, but the results don’t look great looking ahead. Trade policy uncertainty by making supply chain costs harder to predict may reinforce what was likely to be a cyclical slowdown in 2019/2020.

I’ve been concerned for some time that trade uncertainty would make it harder for businesses and indeed households who likely bear the brunt of cost volatility to plan. FX would likely be a major vector of transmission , but uncertainty about supply chain costs, might exacerbate the impact of the tightening of global liquidity implied by the exit of central banks from super-accommodative policies.

I’m not suggesting that trade barriers are the only or even primary driver of decisions, but uncertainty might cause some businesses to hold off on making investments that were already iffy. It might also increase a trend towards deepening of domestic supply chains, which would shift some of the winners and losers in the global economy. Finally it might add to the trend of more consumption rather than investment driven global growth. This seemed a particular risk for countries such as Canada, that are very exposed to U.S. markets, and where the central bank has been concerned that trade uncertainty might be adding to already sluggish business investment.

Perhaps its no surprise that one of the more interesting recent pieces on the role of trade uncertainty comes from a Canadian institution  Meredith Crowley and Dan Ciuriak make an important addition in Weaponizing Uncertainty which does a nice job summarizing recent episodes of uncertainty, vectors of transmission and highlighting ways in which uncertainty on its own might pose a new non-tariff barrier.

One of the biggest questions of the last few years has been when/if trade policy uncertainty might impact global and U.S. growth (see my podcast with hidden forces for a detailed discussion). We may be reaching that time, more so outside the U.S. the U.S. than inside it due to regulatory choices, and fiscal trends, however, U.S. consumers and businesses will be on the receving end of blowback also. Remember, than sizeable earnings of the S&P 500 are from foreign profits.

US policy trends
Recent framing of the U.S. numbers suggest that fiscal stimulus is prompting more of an impact on growth and providing a cushion for administration officials, but doing so is supporting imports, making it even harder for the administration to meet its self-imposed trade deficit goals. Moreover the impact on the USD raises some real questions about dollar funding, especially as the US government has increased its issuance in the market, putting pressure on competitors, exactly as the central bank bid is easing or reversing. This suggests that assessing fundamentals will be important, with weaker fundamental countries and companies providing support.

Chinese response: Could it be easing?
As I’ve noted in past pieces, Chinese policy response is critical to the global outlook, the performance of assets and the transmission. the Chinese policy response shifted form a moderately supportive one (monetary, credit) to a more neutral and slightly tighter one over the last year, amplifying the impact of a relatively tighter fiscal stance. The PBoC balance sheet is now expanding at a slower pace (as local exposures offset for lower foreign currency holdings). The output data from Q2 so far show a cyclical slowdown on the investment side, though not on the retail side. the natural reaction of the Chinese authorities would likely to be to take a slightly easier, stance particularly if they were worried about tightening from the U.S. and supply chain disruptions. This would have the side “benefit” of allowing the CNY to reverse recent appreciation against the basket. The question will come if the CNY starts weakening beyond the basket. 

Note that I think market and policy chatter about the possibility that the Chinese might sell their holdings as relatively ridiculous. While China has been looking for opportunities to diversify the portfolio and aims at shifting the currency risk to non-Chinese actors, a political decision to sell their treasurys would have several detrimental impacts

• increased uncertainty, domestically and abroad including challenges continuing to absorb debt and equity flows. 
• capital losses, especially as its difficult to unload quickly. 
• CNY appreciation vs USD. The last thing Chinese authorities would want is a significant appreciation, suggesting that they may be opportunistic and finance private capital outflows but are unlikely to impose a policy.

If the policy stance does turn easier, and depreciation pressure materializes, this poses a challenge for authorities as it might be difficult to fully control. This suggests moral suasion and domestic policies might be used to limit repatriation. Indeed non-tariff barriers, and even some economic coercion for political aims (core interests such as Taiwan and south China sea) may start to move up again. See my colleagues at CNAS for more on some possible moves.
Are we headed for another crisis? 
Several recent reports (UNCTAD, World Bank) put emphasis on policy uncertainty in reducing long-term investments. I’m not sure trade protectionism can take the full blame here, though it may complicate things. 

Domestic Policy uncertainty around fiscal policy, domestic prices and utility tariffs or infrastructure caps investment in Brazil (though recent IIF analysis on FDI suggests that risk may be overstated) as does expropriation risk in Russia, Saudi Arabia etc. these can add up. in general we have seen much more portfolio debt flows than equity and more short term than greenfield or even brownfield investment. This reflects questions on the business environment at home as well as demand at home and abroad.

I was asked a few weeks ago about worries that trade protectionism would lead to a 2008 like recession. That’s always possible, but I find it hard to see the vector for such a sharp contraction in credit and inability to access global demand. Major tariffs would likely be absorbed through Fx swings and some short Fx positions in usd would be stopped out but I don’t see as much shadow banking risk or collapse in counterparty risk. That’s not to see Macro outlook would be great under a tit for tat trade environment between us and China but the outcome might be more gradual. Key to watch is the policy moves of the Chinese government, especially given the sizeable increase in debt and continued quality of growth issues. 
I think there is likely to be a modest drag to business investment outside the United States particularly in the Americas and Europe and some higher cost Asian producers. This is because the tariffs reinforce some other concerns about final demand- and on the margins tax measures have made it somewhat cheaper to locate operations (finance, services) in the us.
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Then what tariffs matter a lot. Steel and aluminum tariffs will add to inflation and have a modest growth drag, but pretty limited and even nafta withdrawal will only somewhat disruptive in the near term with greater impacts in the medium term. I would be more concerned about the impact of sizeable tariffs on Chinese trade which would have greater impact on global supply chains including a drag of up to a percentage point on us growth and more on some of its trading partners. This is a major reason why it may not get implemented in full. Along the way, it will be harder to plan and financial and other investors may remain more wary. Coupled with concerns about current valuations, justifiying current P/Es looks difficult.
More to come.