Key Points

• Increased possibility of a global trade war following the recent US tariffs announcement
• Two elements for investors to consider: potential of escalation; and the associated signaling effect
• We believe this should be a one-off as Trump plays to his crowd
• However we do not completely rule out the potential for a full blown trade war, and reiterate the need for investors to seek downside protection, given elevated volatility is here to stay

Over the last few days, the markets have been increasingly focused on the specter of a global trade war, triggered by the recent US policy announcement. The Trump administration’s decision to slap tariffs on steel and aluminum caught the market by surprise on Friday. In addition, the rhetoric accompanying the tariffs announcement has been very sharp, led by President Trump himself, and has led to both the EU and Canada reacting with concrete warnings of their own. 

We have focused on protectionism for a while now, seeing it as a key investment risk factor alongside inflation in the current environment (see "America First": the bear who might scare Goldilocks away). We have followed the North American Free Trade Agreement (NAFTA) renegotiations closely since last year (see NAFTA 2.0: the impact is unlikely to be contained to North America), as we believe it provides some insight into the Trump administration’s approach to trade policies. The lack of significant progress on key points of contention suggests the US is taking a hardline stance.

In themselves, the tariffs on steel and aluminum are not significant (spending on steel and aluminum make up around 1% of US GDP and 2% of global trade); however, there are two connected elements to this decision, which are significantly more concerning. 

Firstly, this has the potential to create a domino effect as other countries react to these measures, which could lead to a negative tit-for-tat spiral. The EU reaction has already been met by Trump talking about import taxes on the EU auto sector.

Secondly, there is a potential signaling effect in this announcement as well, whereby this stance reflects a paradigm shift in US trade policy and increases the possibility of a US-China trade war. The US is already engaged in an intellectual property violations investigation against China.

In addition, given Trump’s attempts to distance himself from former White House chief strategist and “economic nationalist” Steve Bannon, these developments have also come with some surprise.

All in all, the re-emergence of protectionism led by the US means we foresee two scenarios going forward, albeit with significant uncertainty until greater clarity emerges: 

Benign scenario – this is a one-off and Trump is only playing to his crowd

So far, US economic policy under Trump has focused on growth-enhancing measures to decrease regulation and reduce taxes. This lurch towards populism is something we have seen before with promises of a border wall and Border Adjustment Tax - but never truly materialised despite the heavy rhetoric. The key here is whether other countries take this as a one-off, crowd-pleasing move by Trump and do not participate to create a vicious cycle. Merkel’s fourth term confirmation is a welcome development in this context, and China’s stance will be equally important. If both of these key blocs do not over-react, there is a strong possibility that this ends with steel and aluminum. In our view these are both insignificant when it comes to the state of the global economy, but still useful ammunition as an over-charged rhetoric.

Negative scenario – full blown trade war

This scenario was last in play right after Trump’s election in November 2016, when fears of a China-US trade war came into focus. At that time, the Trump administration did not follow up on its strong pre-election rhetoric and markets started focusing on his policy views around lower taxes and reduced regulations. However, with tariffs on steel and aluminum, we now have a concrete measure and, as discussed above, the two worrying elements of this policy move are the domino effects of a tit-for-tat vicious cycle, coupled with negative signaling when it comes to US-China trade relations. What puts some additional weight to the probability of this scenario is the direct involvement of two trade hawks, Wilbur Ross and Peter Navarro, as the driving force behind this policy shift, which now seems to be offsetting the positives coming from the departure of Steve Bannon from the Trump administration.

Investment Implications

Our top-level view is that 2018, unlike 2017, is no longer a goldilocks period - now widely confirmed by recent macro and geo-political developments. The global economic cycle is still showing signs of solid growth momentum, but we expect volatility in risky assets to remain elevated as fundamental tensions get more entrenched going forward. To add to that, uncertainty around US trade policy is likely to remain with us for some time before clarity emerges. Currently, we think this is a one-off and will not lead to a full-blown trade war, but we are watching developments closely.

On the political front, Germany’s Social Democratic Party (SPD) confirming its coalition with the Christian Democratic Union (CDU) and Christian Social Union in Bavaria (CSU), is good news as it brings stability to Germany. However, the sharp rise of populism in Italy, confirmed by the latest election results, and a hung parliament there means this medium-term issue in the Eurozone refuses to go away, and if anything, appears to be worsening. 

We still remain constructive on risk given the continued underlying growth momentum, and are positive on emerging markets in particular, as we see the current trade frictions as more of a one-off than the start of a trend. However, we continue to emphasise that volatility is here to stay (and may start to affect emerging markets on a more sustained basis). In that context, seeking downside protection may be a key attribute when it comes to portfolio construction.

For professional investor use only.
This document is issued by Lombard Odier Asset Management (Europe) Limited, authorised and regulated by the Financial Conduct Authority (the “FCA”), and entered on the FCA register with registration number 515393
Lombard Odier Investment Managers (“LOIM”) is a trade name.

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