When Donald Trump was running for President, financial markets were wary of him, not least because of his calls for tariffs and protectionist policies, and it now looks like those fears may be realised, depending upon how America’s trading partners respond.
Such concerns could start to counter the optimism generated by the President’s drive for tax cuts, deregulation and infrastructure spending and counter and weigh on stocks rather than buoy them.
This is because history shows that no-one wins a trade war and four factors in particular could all start to weigh on US and global share prices, if President Trump’s steel and aluminium tariffs draw tit-for-tat responses from America’s trading partners in Europe, Asia or even North American Free Trade Agreement, whether the retaliation comes in the same goods or different ones.
It is likely that President Trump’s plan to impose tariffs on steel and aluminium is particularly aimed at China. America’s total trade deficit in 2017 was $796 billion and imports from China exceeded exports by $375 billion, or 47% of the total shortfall.
China is the biggest single contributor to America’s trade deficit
|Rank||Country||US trade deficit ($ billion)|
Source: US Census Bureau
China represented just 8% of exports but 21% of imports, but it is only the eleventh biggest seller of steel to the US and it only ranks fourth in aluminium.
Leading exporters of steel to the USA
Source: Washington International Trade Association, Global Steel Monitor. Figures for 2016
Canada, for example, is bigger on both counts.
The importance of Canada in not just steel but American trade more broadly explains why both America’s northern neighbour and Mexico have been granted exemptions from the steel and aluminium duties.
America’s ten largest sources of imports and markets for exports
|US exports ($ billion), 2017||% of total|
|Top 10 total||1,000.9||64.7%|
|US imports ($ billion), 2017||% of total|
|Top 10 total||1,644.9||70.2%|
Source: US Census Bureau
This makes sense given the importance of both to US commerce. It also reinforces the impression that China is the real target, although at least a narrowing of the field, when it comes to countries affected, lessens the danger of a major outbreak of additional worldwide trade duties.
But investors need to be on their guard, just in case President Trump imposes further measures – he is now dropping heavy hints about “big items” with respect to the EU, which some are interpreting to mean cars.
History is by no means guaranteed to repeat itself but the precedents for prior tariff plans are not exactly encouraging and there are four issues to watch should the steel and aluminium duties prompt a retaliatory response from affected nations or America add more products to the list of products affected by the new duties.
Four themes to watch
1. The lessons of Smoot-Hawley. Economists agree on very few things but one of them is that 1930 Smoot-Hawley Tariff Act worsened what was already a difficult situation, contributing to the Great Depression of the 1930s. The bill introduced by Senators Reed Smoot and Willis Hawley slapped tariffs on over 20,000 types of imported goods. Key trading partners responded and after initial gains in industrial output and employment, imports and exports started to shrink to the marked detriment of both and therefore wider US and global economic output.
2. Inflation. While US steel and aluminium makers (and their workers) may be happy, it remains to be seen whether US consumers feel a benefit as there has to be a danger that the price of imported goods goes up, nudging inflation higher, even if the plan is to let increased domestic output compensate for the drop in imported materials. Car makers and construction firms will be watching nervously, as will would-be buyers of cars and property developers to name a few.
According to the World Steel Association (WSA), the construction industry consumes 50% of global steel output. Mechanical equipment (such as cranes and oil rigs) consumes 16% and the auto industry 13% – the WSA asserts that the average car contains around 900kg of steel.
Global steel consumption by industry
Source: World Steel Association
It is hard to see construction or car companies being pleased by the higher prices that could result from higher steel duties, especially when car sales volumes are already slackening in the US.
US inflation is already creeping slowly higher
Source: FRED – St. Louis Federal Reserve database; New York Federal Reserve
3. US interest rates. The US Federal Reserve will be watching with interest too, especially if the development of a protectionist agenda beyond the US, in retaliation, does start to fuel inflation, at least initially. The central bank is already reducing QE and seems intent on pushing through at least three interest rate increases in 2018. That would make eight for this tightening cycle, which began in 2015, or a 200 basis-point (two percentage point) increase in the Fed Funds rate. Since 1970 an average increase of 2.18% has helped to cool the top in US stocks, although the range across the eight cycles is wide:
How far US interest rates have risen before prior stock market peaks
|Date||S&P 500 peak level||Fed funds rate at S&P peak||Change in Fed Funds cycle before||Change in Fed Funds cycle before S&P 500 peak|
|11-Jan-73||120||5.50%||3.50% to 5.50%||2.00%|
|21-Sep-76||1,008||5.50%||4.75% to 5.50%||0.75%|
|28-Nov-80||141||15.00%||4.75% to 15.00%||10.25%|
|10-Oct-83||173||9.38%||8.50% to 9.38%||0.88%|
|25-Aug-87||337||6.63%||5.88% to 6.75%||0.88%|
|16-Jul-90||369||8.00%||9.81% to 8.00%||-1.81%|
|24-Mar-00||1,527||6.00%||4.75% to 6.00%||1.25%|
|09-Oct-07||1,565||4.75%||1.00% to 4.25%||3.25%|
|Average excl. 1990||2.75%|
Source: Thomson Reuters Datastream
4. The dollar. The USA runs a trade deficit for the simple reason that America consumes more than it makes, so it has to import more goods than it sells, in turn spending more dollars than it earns. It is that simple. If President Trump succeeds in his plan to lessen or erode the trade deficit, then it seems logical to expect an increase in the value of the greenback as fewer dollars are exchanged for overseas goods and supply, and the US currency is held in check.
Perverse as it may seem, a strong dollar has tended to be bad for global markets.
Since President Richard M. Nixon and Treasury Secretary John Connally smashed up the Bretton Woods agreement in 1971, withdrawing America from the gold standard and ushering in the era of free-floating currencies, the dollar has enjoyed two huge bull runs.
Dollar has enjoyed two major bull runs since early 1970s (and suffered three major sell-offs)
Source: Bank of England, Thomson Reuters Datastream
The first ran from the mid 1970s to 1985, as then Federal Reserve Chair Paul Volcker jacked interest rates up to 19% so he could crush inflation. That period included the 1982 Mexican debt crisis and considerable financial market volatility and it took September 1985’s Plaza Accord amongst (what was then) the G5 to officially devalue the greenback against the yen and deutschmark to halt its progress.
The second ran from 1993 to 2000, a period which included another period of emerging market instability in particular, with the 1994 Mexican peso devaluation (the so-called ‘Tequila sunset’) and the 1997-98 Asian and Russian debt crises. A Fed-backed bail-out of the LTCM hedge fund helped to smooth that over and the dollar’s rise was eventually checked by a recession and interest rate cuts in 2001-03.
Stock markets, and especially emerging markets (EM), are therefore always wary of a strong dollar as a bouncy buck is inherently deflationary: a strong greenback increases the cost for non-dollar nations of funding their dollar-denominated debts and it makes dollar-priced commodities more expensive in local currency terms.
Emerging market equities and the dollar have historically had an inverse relationship
Source: Bank of England, Thomson Reuters Datastream
The counter-argument to this, regularly posed by experienced EM fund managers, is that many emerging market companies now have a broader geographic spread of business and now naturally have a better balance of assets and liabilities between local and overseas currencies.
For the moment, this theory has yet to be tested as the dollar has gone down amid the initial concern over the President’s tariff plan, although that has helped to reaffirm the old (inverse) relationship between the US currency and EM assets, as the former has gone down and the latter held relatively firm.
Russ Mould, AJ Bell Investment Director