Fanning an Inflationary Fire?

Trading relationships between nations are changing. Protectionism has been rising, and with it the prospect of inflation is mounting. If full-scale trade wars erupt, worries will grow around how much more consumers will pay for goods and services, and as to what the impact will be on still-fragile economic growth.

In March, the U.S. Trump administration announced tariffs of 25% on steel imports and 10% on aluminum imports, and followed this with a further U.S.$50bn of tariffs targeting Chinese-made goods. In turn, China announced tariffs of its own on up to U.S.$3bn of U.S. imports.[1] Europe has since been largely exempted from the U.S. steel tariff, but trade negotiations with the UK are under way, with the latter attempting to put in place some 40 trade arrangements with 70 countries by the end of the Brexit transition period in 2020.[2]

Trade tensions

Against this backdrop, we fear that rising trade tensions could escalate into a full-blown trade war, which would be damaging for growth, global markets and investors. While we would rule out the ‘Armageddon’ scenario of soaring inflation and central banks hiking interest rates in step with inflationary change, we believe that trade tensions present real economic risks to investors.

Such a scenario could lead to higher prices for consumers and companies. If businesses can’t pass increased costs through to consumers, they will see their profitability deteriorate. If we do get a trade war and rising inflation, it will most likely be driven by ‘bad’ inflation that puts extra costs onto consumers, rather than by more positive wage inflation. To some extent, everybody would be a loser in a trade war, but consumers will be hardest hit.

That said, a few companies may make gains on the back of increased trade actions. We believe that, if we are moving towards a world where globalisation is unwinding, beneficiaries could be the very industries that lost out from it – such as U.S. steel manufacturers. This would, in turn, fit the narrative of the U.S. administration’s ‘America first’ agenda quite well.

From an investment standpoint, we would expect to see growing market volatility and increased uncertainty about the direction of economies; against this backdrop, the likelihood of a slackening in appetite for risk assets would grow.

On the other hand…

Rising inflation and renewed fears over global growth could also prompt major new inflows to so-called ‘safe-haven’ fixed-income assets such as government bonds. We believe index-linked bonds could also benefit as expectations of increased inflation grow. Despite rising fears over growth prospects in a global trade-war environment, we believe central banks, such as the U.S. Federal Reserve (Fed), are well equipped to adjust to the new financial pressures it could create. We also think some sectors of the U.S. economy may remain well placed for future growth. The Fed and other central banks will be cognisant of the impact a trade war would have on the economic backdrop. They will take this into account when formulating policies and gauging the pace of unwinding quantitative easing, and will most likely adjust accordingly.

While there are some genuine concerns that trade barriers could affect business sentiment, domestic tax cuts and accelerated depreciation look likely to increase capital expenditure in the U.S., with some parts of the economy expected to continue to grow. In such a scenario, economic growth could surprise, and may favour risk assets.

[1] CNN: ‘Trump hits China with tariffs, heightening concerns of a global trade war’, 23 March 2018.

[2] BBC: ‘Brexit: UK hopes to roll over 40 EU trade deals, says Liam Fox’, 29 March 2018.

Authors

Paul Flood

Head of mixed assets investment