Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 273

It’s getting hot in here

Tariff wars, emerging markets in crisis, and the US economy overheating … where does one start when trying to work out what it all means?

Well, as always I like to start with history. Have we seen this before? Pretty much. We have many historical examples to ponder, and so many possibilities, but for me the 1960s and the 1990s come to mind.

Let’s start with tariffs. Is it simply brinkmanship, where Trump’s true desire at the end of the day is to force the Chinese to lower tariffs? Or is it something more pernicious, perhaps a multi-decade turning point in globalisation?

If brinkmanship, how will it end? The market assumes rather gently, with the US stock market generally happy to look through the shenanigans and assume a positive end result. Perhaps that will be the case, but key to securing large concessions through brinkmanship is not only threatening large repercussions, as Trump is currently doing, but convincing your combatant that you are deadly serious about following through. More often than not, deadly serious means actually following through.

Kennedy knew this. For a perspective on successful brinkmanship, one can’t go past 13 days in October, 1962 – the Cuban missile crisis. In August 1962, the Soviet Union snuck nuclear missiles into Cuba (in response to the US placing nuclear missiles in Turkey three months earlier) and assembled launch pads before the US noticed. Despite some suspicions, the US did not realise that a nuclear arsenal had been deployed until 14 October when aerial reconnaissance confirmed launch pads and missiles ready to go in Cuba.

Kennedy threatened to invade if they were not removed. The Soviet Union protested. The missiles in Cuba were purely for Cuba’s defence, and any invasion by the US of Cuba would trigger a war with the Soviet Union. Kennedy publicly moved to DEFCON 2 and said that the United States will:

" ... regard any nuclear missile launched from Cuba against any nation in the Western Hemisphere as an attack by the Soviet Union on the United States, requiring a full retaliatory response against the Soviet Union."

After some rather tense exchanges, they took his threat seriously, and agreed to remove the missiles. Pretty heavy brinkmanship when the consequences of escalation were so high for both parties. See: http://www.nuclearfiles.org/menu/key-issues/nuclear-weapons/history/cold-war/cuban-missile-crisis/timeline.htm

Of course we are not talking about the same consequences here. But we are talking about the same game, namely the game of brinkmanship. To get big concessions, big threats need to be made convincingly. Which as we are seeing, needs some follow through. Sometimes the outcomes aren’t as intended. Beyond brinkmanship, there are a few other examples that come to mind.

Perhaps inflation breaking out, like in the late 1960s when the Fed allowed unemployment to breach new lows? Or can the US economy handle stronger growth, like the productivity surge Greenspan embraced in 1996-97 to forestall rate hikes? Or does none of this matter, because we are about to repeat an EM crisis like 1997-98? Perhaps there is no historical analogue? After all, we don’t have a historical analogue of 10 years of zero to negative interest rates in the major economies of the world, combined with 18 trillion dollars of bond purchases by their central banks! (But we do have analogues of low interest rates generating financial bubbles) Do you have a conviction? If you are highly convicted, perhaps you should heed Alexander Pope’s famous phrase, “A little knowledge is a dangerous thing”! Nonetheless, I think one can have conviction in how scenarios might play out. So let’s start with the scenarios.

The scenarios

1. Tariff escalation. If Trump imposes a tariff of 25% on US$200 billion of US imports from China, and particularly if he follows it up with another US$267 billion of tariffs, that is all that will matter for markets in the next 6 months. With the latter, one can’t escape both a significant growth and inflation impact in coming months. EM equities will fall a further 10-15%, and US equities will likely fall 5-10%. The USD would soar 5-10%, at which point the Fed stops hiking.

2. Tariff de-escalation. If the US agrees a resolution with China, the focus turns back to the current status of the US economy. It is too strong. Initially equities rally, the USD likely falls as emerging market equities outperform, and bond yields rise markedly. At some point in the next 6-12 months the market realises the Fed needs to take a restrictive policy to slow the economy and quell inflation, and a recession gets priced in.

3. A bubble bursts. What bubble? As I wrote in June, after 10 years of zero interest rates and low bond yields, money has poured into any bonds that give a little extra yield. We have seen the wobbles already.

At the moment, with the unresolved tariff war, it is impossible to be emphatic. But the time is nigh when it will pay to be very decisive indeed. And conversely, a disaster, potentially, if you are not.

Am I being too alarmist? Or even too simple? Let me give you some facts, after which you can decide.

How bad can a tariff war be?

Well I could start with the Bank of England’s prognosis:

Wow, 5% off US growth …

However, note there are some pretty dire assumptions in there. Firstly, they assume every country imposes a 10% tariff. The impact of that is shown in the dark blue (about half the overall impact). The rest of the impact comes predominantly from higher bond yields, lower equity markets, and greater uncertainty. There is no assumption of stimulus, either from rate cuts or fiscal policy (which has just had a windfall from the tariff ‘tax’).

So it is fair to say that the impact would be much less than this. But how much? Well the first point is we don’t know what the final tariffs are yet. But if Trump proceeds with tariffs on all Chinese imports (about $500 billion), as he is threatening, reasonable estimates would see a growth impact of 1-2% for each economy. And that will hurt.

Of course, many assume this is nothing more than brinkmanship. A game of chicken. As John Cirace argues, to win the game of chicken, the individual must “create the impression that nobody is crazier or badder than me”. [Law, Economics and Game Theory. John Cirace, page 120]. Ipso facto, Trump will win!

Or crash ... I’m not sure he realises crashing is a possibility. So he just might not see it coming. What does a crash look like? US stocks down 10%. That would get his attention, though not necessarily a reaction.

Will it happen? Well, by the time you are reading this, the answer might be clear. But I strongly believe as I write, one cannot hold a view on the evolution of the confrontation with conviction. We pay many consultants who are experts on Chinese and US politics. The more you know, you realise the less you can be sure.

 

Brett Gillespie is Head of Global Macro at Ellerston Capital and has worked in the financial services industry for over 28 years. This article is for general purposes and has been prepared without taking account your objectives, financial situation or needs.

RELATED ARTICLES

Just how reliant on China are we?

The 2020 US presidential elections

Three leading Aussie stocks dependent on China

banner

Most viewed in recent weeks

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Latest Updates

Strategy

$1 billion and counting: how consultants maximise fees

Despite cutbacks in public service staff, we are spending over a billion dollars a year with five consulting firms. There is little public scrutiny on the value for money. How do consultants decide what to charge?

Investment strategies

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Financial planning

Reducing the $5,300 upfront cost of financial advice

Many financial advisers have left the industry because it costs more to produce advice than is charged as an up-front fee. Advisers are valued by those who use them while the unadvised don’t see the need to pay.

Strategy

Many people misunderstand what life expectancy means

Life expectancy numbers are often interpreted as the likely maximum age of a person but that is incorrect. Here are three reasons why the odds are in favor of people outliving life expectancy estimates.

Investment strategies

Slowing global trade not the threat investors fear

Investors ask whether global supply chains were stretched too far and too complex, and following COVID, is globalisation dead? New research suggests the impact on investment returns will not be as great as feared.

Investment strategies

Wealth doesn’t equal wisdom for 'sophisticated' investors

'Sophisticated' investors can be offered securities without the usual disclosure requirements given to everyday investors, but far more people now qualify than was ever intended. Many are far from sophisticated.

Investment strategies

Is the golden era for active fund managers ending?

Most active fund managers are the beneficiaries of a confluence of favourable events. As future strong returns look challenging, passive is rising and new investors do their own thing, a golden age may be closing.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.