In the first year of his presidency, Donald Trump has been less aggressive on trade than expected, especially considering his rhetoric during the campaign. His only major decisions on that front was the withdrawal of the US from the Trans-Pacific Partnership (TPP) and the imposition of tariffs on Bombardier planes and Canadian softwood lumber.

This is likely to change this year. The US President will make a speech at the World Economic Forum in Davos on 26 January, in which he is expected to explain his “America First” vision and what it means for the rest world. In addition, it is also likely that President Trump decides to use his State of the Union speech on 31 January to announce some of his protectionist agenda.

More retaliatory tariffs

The Trump administration needs to make a number of trade decisions this month. The Trump administration has already taken some protectionist steps in recent days by imposing tariffs on imports of solar panels and washing machines. It needs to decide whether steel and aluminium imports impair national security and whether to impose retaliatory actions. It will also release the result of its investigation into China’s alleged intellectual property theft and its response to the findings.

That last point is the one that we believe puts the most risk on the global economy and is likely to generate the most friction with China. There are various ways the Trump administration could retaliate if it declares that China has caused harm to the US through intellectual property theft. It could:

1. Impose symbolic measures to China to compel China to change its way
2. Impose tariffs and warn that if China does not act to change its ways it will announce further measures against China, including potential investment restrictions in the US,
3. Introduce wide ranging tariffs and investment restrictions against China.

Fuel for a trade war

We believe that the most likely outcome will be the second option. It makes a good compromise between Trump’s promise to impose trade restrictions on China, while remaining appealing to the pro-trade members of his administration and Congress. In this case, China would likely respond with import tariffs and non-tariff barriers, mainly in the agricultural and food sector. China could also curb its investment in the US. Already, news reports have hinted that China could sell some of its US Treasury bonds, even though it was denied that this was an advance warning.

In our view, a major risk is that a tit-for-tat approach will degenerate into a full-fledged trade war – a low probability outcome at this juncture, but one with damaging negative consequences for the global economic outlook.

Made in America: NAFTA at risk

In addition to these decisions, the US, Canada and Mexico are currently renegotiating the North American Free Trade Agreement (NAFTA). After the latest round of negotiations in November, it seems that parties have drifted further away from each other. This is mainly the result of the markedly protectionist US proposals, including: a sunset clause (automatic termination of a deal after five years unless all countries agreed to continue); a significant change in the “rules of origins” for cars that governs how much of a car has to be manufactured in North America to avoid import taxes (to 85% from 62.5%); a requirement for 50% of a car’s content to come from the US, and an increase in US companies access’ to Mexican and Canadian government contracts without reciprocity.

The proposals above have been rejected by Canada and Mexico without making any counter-proposals. Coupled with the intransigence of the US negotiators, this has led to a breakdown of trade talks. The US Chief Negotiator, Robert Lighthizer, has said that Canada and Mexico need to offer counter-propositions, while President Trump has expressed that the current situation did not bode well for NAFTA - suggesting that he could announce his decision to withdraw from the NAFTA agreement. On the Canadian side, an official reportedly said this month that he sees the probability of Trump leaving NAFTA as rising.

Make or break talks

The current round of negotiation could be a “make or break” situation, hinted at by the decision of holding nine days of negotiations instead of six as originally planned. If the Trump administration judges that not enough progress has been made, we believe that President Trump is very likely to trigger the NAFTA 6-month withdrawal notice period. We would view this decision as a negotiation tactic by the Trump administration to impose an ultimatum, force concessions from the other side and ensure that a deal is reached before the Mexican elections this summer. This is very similar to what President Trump did with the Deferred Action for Childhood Arrivals (DACA). At this point we believe that the probability of a NAFTA break-up is only marginally below 50%. But our base case remains that a compromise will be found (see NAFTA 2.0: The impact is unlikely to be contained to North America)

Weak dollar preferred

It had been a tradition started by Robert Rubin in the mid-1990s, for the US Treasury Secretary to say that the US has a ‘strong dollar policy.’ But this is changing under President Trump. Current Treasury Secretary, Steve Mnuchin, broke this tradition by telling reporters in Davos that “obviously a weaker dollar is good for us as it relates to trade and opportunities,” confirming that the US currently welcomes a weak dollar.

The dollar has already depreciated by almost 10% since the end of 2016. Interestingly, the USD has diverged from the rates differential, notably versus EUR. Part of the reason is the lack of willingness by financial markets to price in a path of hikes that is as aggressive as the Fed’s projection. However, other factors are likely to contribute to pushing the USD lower: the explicit preference for a weak USD by the Trump administration; the increased uncertainty and risk of trade wars stemming from the “America First” agenda; the twin current account and fiscal deficits; and the fact that US growth is no longer outperforming the rest of the world.

Impact of a weak dollar

A weak dollar has implications for the global economy. Firstly, it pushes commodity prices higher through the ‘numéraire effect.’ However, the resulting inflationary impacts are asymmetric; more positive for the US than the rest of world, as the appreciation of non-USD currencies soften the impact of higher commodity prices on inflation. For example, the S&P GSCI has increased by 15% in USD, but is flat in EUR. Secondly, it pushes US inflation higher by making imported goods more expensive, not just commodities. With conditions in the US ripe for inflationary pressures to pick up, thanks to a tighter labour market and higher commodity prices, this would mean a more aggressive Fed and we believe that the Fed will hike four times this year (see Inflation risks rise as US economic slack erodes). Thirdly, it reduces US demand for imported good, slowing exports growth elsewhere. However, given the broad-based strength of the global economy, this impact is likely be marginal.

A weak USD would have an impact on financial markets by making US assets less attractive to foreign investors. This is especially true for fixed income assets, where a yield premium may be demanded by foreign investors to compensate for the depreciation risk. For equity, it is less definitive, as a weaker USD will be positive for the profitability of US corporations with big foreign revenues. In emerging markets, a weaker USD benefits both local currency bonds and USD-denominated bonds through the FX impact on the holding value for the former and easier repayment for the latter.

Investment implications

We believe that the “America First” agenda of the Trump administration and its potential to degenerate into a trade war and disrupt global trade is a major risk to the current “goldilocks” environment and global growth – which remains our base case scenario for 2018H1 (see 2018 Outlook: Big Bang or Steady State?).

Equities may suffer

The impact on financial markets could be huge, given the high valuations of many asset classes. The protectionist risk highlights the need for investors to diversify their portfolio, seek to mitigate any potential shocks and establish an ex ante drawdown management policy. The asset classes most at risk, in this case, are global equities, especially emerging markets (mainly Asia and Mexico), Canada and the US. Corporate bonds in those regions could also underperform, given the uncertainty regarding future profitability the situation would create. As such, we will be monitoring the developments on this front very closely, given our positive emerging markets thesis.

Nevertheless, on a positive note for the global economy, simply because the US administration has taken a protectionist path does not mean that the rest of the world will automatically follow. The announcement by the Canadian Prime Minister at Davos that an agreement had been reached for TPP and that the accord would be signed in March shows that other parts of the world remain open for business. Similarly, the decision of China to go ahead with its “One belt, one road” initiative to build trade routes with the rest of the world proves that globalisation may not be dead, but that its leaders and main influencers will be in the East. Perhaps Goldilocks will sleep a while longer yet.

Any reference to a specific security or asset class does not constitute a recommendation to buy, sell, hold or directly invest in the company or securities. It should not be assumed that the recommendations made in the future will be profitable or will equal the performance of the securities discussed in this document.  

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