On hawks, canaries, and trade wars
The halls of power in Washington are increasingly filled by hawks. Out are the ‘globalists’ from Gary Cohn to Rex Tillerson. And in are Robert Lighthizer and Peter Navarro, who are driving a more combative US trade agenda, as well as hardliners John Bolton at the NSA and Mike Pompeo at State. And the President is acting in an increasingly unconstrained way, including on trade, announcing retaliatory tariffs by tweet.
The Federal Reserve is also looking more hawkish, albeit in a technocratic way, seeming committed to at least three rate rises through 2018. The only hawks that are missing are the deficit hawks, with the CBO this week projecting fiscal deficits in excess of $1 trillion by 2020.
This hawkishness in the US is matched by an uncompromising tone out of Beijing. Although President Xi’s speech at the Boao Forum on Tuesday offered trade concessions on the surface, most of these had been made before. Markets have over-interpreted what was said.
"China is unlikely to significantly change its trade and economic behaviour, particularly so soon after the Presidential term limits were removed. "
Taken together, actions in Washington and Beijing have increasing potential to be disruptive for markets and the global economy. Indeed, market volatility has spiked up over the past few months after a very calm 2017. Year to date, major US, European and Asian benchmarks range from roughly flat to down 3-5%. But these markets have been turbulent, responding to changing daily sentiment on the trade outlook.
One useful place to calibrate the expected economic impact of the hawks is to look at the reaction of small advanced economies – the canaries in the mine of the global economy. These economies, from Singapore to the Netherlands and Sweden, have an acute exposure to global trade and investment.
And yet these canary economies have not been impacted disproportionately by heightened trade concerns. Year to date – and since March 1 – equity indexes in my small economy group have performed in line with global benchmarks, down by 1%. And Singapore, a bellwether economy, is down just 2% since March 1. Although small economies with larger external exposures (such as Hong Kong) are down by more than countries with smaller exposures (such as New Zealand, which is up since March), this does not change the underlying picture. Similarly, small economy bond yields and exchange rates have been reasonably quiet.
Neither have small economy markets been particularly volatile. The standard deviation of daily returns in small economy equity markets has increased relative to 2017, but remains well below the levels of mid-2015 and 2011. The large economy markets of the US, Japan and Germany have been moving around more sharply.
Overall, there does not seem to be particular market concern in small advanced economies about the potential for broader trade conflict. This is perhaps reassuring. But my assessment is that this market pricing reflects the short-term outlook – where the economic and market impact is likely to remain contained, outside directly impacted sectors – rather than where this will end up.
And over a horizon of a few years, my sense is that the market consensus is too optimistic. Some regard the rhetoric and the retaliatory tariffs as a noisy negotiation in which the US is trying to get bargaining leverage. And that China because of its relatively heavy reliance on the US will offer concessions on market access. This is possible, and it may be that a new equilibrium of sorts can be reached.
But Mr Trump may be over-estimating his leverage over China. At best, this will likely be a messy, iterative process with partial concessions followed by new threats. China is likely to try to reduce these risks through measures such as purchasing more US LNG and agricultural products or promising more opening up. But there are limits to what it will do. Mr Trump’s lack of reliability also means that China will be wary of making concessions that are not treated as final by the US (as Mr Trump did with KORUS).
There are also some fundamental differences in interests, and the underlying issues are not easily soluble. The US trade deficit – Mr Trump’s preferred metric – reached a 9-year high in January, and will not be easy to bring down given the US fiscal outlook. And there are limits to what can be done in terms of the bilateral trade deficit. This reality will complicate the permanence of any negotiated solution, as with Japan in the 1980s.
And more importantly, China is unlikely to meaningfully alter its industrial policy (such as ‘Made in China 2025’). At the centre of the US section 301 action was a complaint about the role of the state in the economy, underpinned by a conviction that China is now a strategic rival. But this approach is at the core of the Chinese system. To be sure, there are legitimate complaints about Chinese policy. But the US has undermined its ability to lead a global coalition of concerned economies, such as the EU and Japan, on these issues.
Overall, 2018 will likely continue as it has started: escalating trade tensions, with associated market and economic costs and volatility, partly managed through a series of rolling negotiations. This will be short of a trade war. But it is not a stable solution, and without a change in strategic direction from the US or China, a more fundamental collision is likely in the next few years. When that happens, the canaries will be at greater risk from the hawks.