Investors might need a strong stomach this year. Markets have been whipping around while investors struggle with headlines about trade tensions.
Some may say the market’s response to US action on Chinese trade has been a little irrational. Consider that proposed tariffs on about $50bn worth of Chinese imports motivated declines of about 5% in equity markets, erasing around $4tn in global market capitalisation. In other words, the equity market reaction was almost 100 times greater than the total value of goods directly affected by the tariffs.
It’s not entirely irrational. Investors are not only reacting to the direct impact of those tariffs, but also to potential retaliation from China and the threat of a trade war. Yet, while we must be mindful that a severe trade war would clearly have a significant negative impact on global growth, the risks of such an all-out event unfolding are still low. Several countries have been temporarily exempted from the tariffs, suggesting that President Trump is not seeking a trade war, but a renegotiation of trade terms.
And as much as protectionist rhetoric may win Trump some support in the mid-term elections, a stock market decline would most likely lose him votes. In an environment in which the Federal Reserve is raising rates, equity markets will tend to be extra sensitive to anything that can damage growth prospects.
Hawkish Fed policy + threat of trade war = potential danger.
Most Federal Open Market Committee members now expect the policy rate to reach 3.25%-3.5% by the end of 2020. This could be achieved via three more hikes in 2019 and a further two in 2020. That compares to market pricing for just one more hike in 2019 and nothing in 2020, a considerably more dovish outlook.
This is where things get interesting. At the end of January an inflation scare caused markets to raise their 2018 interest rate expectations to meet the FOMC’s more hawkish projections, triggering the equity market correction. What happens if stronger than expected inflation data – perhaps because of trade tariffs driving import prices higher – prompts a similar re-pricing of the market’s 2019 rate expectations? Another spike in bond yields would leave the equity market heavily dependent on strong global growth to carry it through. If the threat of a trade war is still present, markets would struggle to stabilise.
Trump has repeatedly cited the rising stock market as proof that his presidency has been successful. A trade war is not in the US administration’s interests and recent negative market reaction to trade tariffs should moderate their approach. Barring a policy error, the more immediate threat from trade tariffs is that markets continue to be disrupted by greater uncertainty and higher volatility. Be mindful of trade risks, but watch interest-rate risk even more.
Seema Shah is Global Investment Strategist at Principal Global Investors. This article first appeared on the Short and Sharp blog.