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March 2018

Dissecting the cost of trade war

Here’s why the world’s two biggest economies want to avoid an all-out trade war.

After having their nerves tested in recent weeks, investors are hopeful the US and China can avert a full-scale trade war.

So are we. The rhetoric emanating from Washington and Beijing is, we believe, simply the initial phase of a negotiation that will result in a new trade agreement.

Still, as our calculations show, the stakes are high.

A trade war – however improbable – would tip the global economy into stagflation and lead to a sharp decline in world stocks.

Our model, which is based on IMF estimates,shows that if a 10 per cent tariff on US trade were fully passed onto the consumer, global inflation would rise by about 0.7 percentage points. This, in turn, could reduce corporate earnings by 2.5 per cent and cut global stocks’ price-to-earnings ratios by up to 15 per cent.

All of which means global equities could fall by some 15 to 20 per cent, assuming that US bond yields rise in line with inflation.

Under such circumstances, the shares of Chinese exporters and cyclical US stocks – in particular expensive sectors like consumer discretionary – would probably suffer the most.

History suggests that the erection of trade barriers is bad for equity markets: the S and P 500 fell 10 per cent in the three months after US President Richard Nixon imposed a 10 per cent tariff on imports in mid-1971.

It is important to stress that this is not what we expect to happen. These calculations merely serve to highlight why we believe the US, China (and the EU, for that matter) will do whatever it takes to avoid the worst possible outcome.

We don’t believe that hampering the flow of goods and services is in anyone’s interests. As the IMF’s chief Christine Lagarde observed, nobody wins a trade war.

lower tariffs, more trade

The level of tariffs and the volume of trade have displayed high correlations in the US

US trade import export

Source: Thomson Reuters Datastream, data covering period 15.02.1955 - 15.11.2017