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The U.S. slapping import duties on washing machines and solar panels, China portraying itself as a paragon of openness – recent developments around global free trade have raised eyebrows. But while the headlines may be dismal at times, the reality is different. Given that free trade has more often than not greased the wheels of the global economy over the past decades, the protectionist noises coming out of Washington may be primarily designed for the gallery.
Since the collapse of the former Soviet bloc in 1989, growth in global trade has consistently surpassed economic growth. It worked as a reliable booster for the global economy until the great financial crisis of 2008/2009. Things changed after that. From 2012 until the middle of 2016, global trade was a drag on global economic growth, reversing a well-established trend. Over that period, the troubles of global banks deprived global trade of vital financing. The collapse of commodity prices also played a role. However, since the middle of 2016, global trade is again buoyant, sustaining a broad global expansion across most markets (see chart 1).
Chart 1: Global trade growth is surpassing global economic growth again since mid-2016
Source: CPB, IMF; Thomson Reuters Datastream, Vontobel, Vontobel
With the political rise of Donald Trump, the U.S. seems to have lost its status as champion of free trade. The U.S. administration has recently raised import tariffs on solar panels and washing machines. Moreover, based on the recommendations from the Trade Department, tariffs or quotas on steel and aluminium imports will soon follow. Oddly enough, the rationale behind these cases would be that such imports impair national security. Is global trade about to be derailed, with negative consequences for the global economy?
We do not think so. On the one hand, trade disputes are the consequence of the U.S. president’s agenda, where the suppression of imports is one of the top priorities. On the other hand, washing machines, solar panels, steel and aluminium together account for only 1.6 percent of global U.S. imports and 0.2 percent of the country’s gross domestic product (GDP). Moreover, we expect China, South Korea and Japan to react in a measured way as they understand the need of some U.S. posturing ahead of mid-term elections. The North American Free Trade Agreement (NAFTA) – Donald Trump’s bête noire of old – is a case in point. So far, the talks between the three NAFTA parties, the U.S., Mexico and Canada, show that the world’s biggest economic power isn’t much interested in rocking its neighbors’ boat. This can be seen from the deferral of the talks until after the Mexican general elections in July or even after the U.S. mid-term elections in November. Therefore, despite negative headlines, we expect global trade to remain a key contributor to global growth in the period ahead.
Moving to equity markets, February has seen the first 10-percent correction since the Chinese-led global drawdown between November 2015 and February 2016. In addition, the Chicago Board Options Exchange Volatility Index (VIX), also known as “fear index”, hit a stunning high of 50 percent on February 6. Granted, investors had been euphoric previously, so markets were vulnerable to any (perceived) bad news. This came in the form of rising wage growth in the U.S. (up 2.9 percent in January 2018 year-on-year) and core inflation data slightly above expectations. While we now give our “inflation scare” scenario (see Investors’ Outlook from December 2017) a higher probability of occurrence of 30 versus previously 25 percent, “Goldilocks, again” remains our central scenario with a probability of 60 percent. We stick to our neutral equity positioning and underweight stance on government bonds while gradually trimming our holdings across bond segments such as high-yield or emerging-market debt. Our equity mix is tilted towards “value” with bank and commodity-related stocks accounting for a substantial portion of our exposure. Such positions would benefit from a gradual pick-up in inflation and continued real economic growth.
A rising concern for us and investors in general is the potential impact of the U.S. spending plan for 2018 and beyond, especially when taking into account the recently enacted tax cuts. This will lead to a surge in the budget deficit to 5 percent (versus 3.6 percent for 2017) and above. Since the 1960s, such a level has only been reached during or shortly after recessions (see chart 2). Given the country’s structural current-account deficit of around 3 percent of GDP (despite lower imports of oil and gas), its financing needs might coincide with a period of rising interest rates. With the U.S. Federal Reserve reducing purchases of government bonds, financial markets could soon drown in a flood of U.S. Treasuries. This means that U.S. dollar bonds will have to maintain a significant interest rate advantage over other safe government paper to remain attractive to foreign buyers. In spite of the higher coupon that such issues will have to carry, the U.S. dollar could come under substantial pressure should doubts emerge about the sustainability of U.S. fiscal policy. A sudden rise in U.S. Treasury yields – beyond economically justified levels – could start constraining asset prices or wreak havoc in financial markets. This is a risk we will need to watch.
In this context, the forthcoming U.S. inflation and wage growth figures will be particularly important. Any number (again) coming in above expectations might trigger another wave of risk aversion. It goes without saying that we will remain vigilant and act swiftly if need be.
Chart 2: U.S. budget deficit above 5 percent (2018 and beyond) is without precedent outside of recessions
Source: U.S. Bureau of Fiscal Services, Bureau of Economic Analysis, Congressional Budget Office, Joint Committee on Taxation, National Bureau of Economic Research, Thomson Reuters Datastream, Vontobel