Though still highly unlikely, we do not entirely rule out an all-out trade war. It would take near-complete disruption of trade flows to threaten recession in the US.
- Western Asset believes a holistic perspective is invaluable to help frame the risks associated with this rapidly developing situation.
- While we remain optimistic that global growth will remain on a positive trajectory, we acknowledge the possibility that a further escalation of trade tensions could have deeper consequences for the global economy and financial markets.
- A full-blown trade war with China would raise the risk of a US recession; while such a full-blown trade war is still highly unlikely, we do not rule it out entirely.
- While foreign trade is important, it is not a life-and-death aspect of the current US economy, as it would take near-complete disruption of trade flows to threaten recession in the US.
- The initial round of tariffs will likely raise consumer prices. However, its effects are unlikely to be persistent and will likely have almost no impact on Fed policy or long-term inflation.
- Since our last report, the list of sectors with a “high” risk rating has expanded to include capital goods and consumer products.
- In this fragile environment, our sector teams globally remain vigilant in monitoring industry developments, revenue and margin trends, management sentiment, and valuations, then revise their opinions accordingly.
“While we remain optimistic that global growth will remain on a positive trajectory, we acknowledge the possibility that a further escalation of trade tensions…could have deeper consequences.”
The View From Above
Exhibit 1: Markets Are Reflecting Continued Policy Accommodation to Support Growth
A trade war with Mexico would not tip the US into recession, either. That stated, the Trump Administration’s attempt to address the US border situation by threatening tariffs on Mexico is troublesome on two counts. First, the threat came shortly after progress on a renegotiation deal with Canada and Mexico. By threatening trade sanctions with Mexico so soon after negotiation of a successful trade deal with them, the Administration can be seen as doing exactly what China is often reputed to do: using a completed deal as a pretext for further negotiations rather than a .rm basis on which to conduct business. Second, by mixing trade policy and immigration policy, the Administration is opening a potentially wide door through which trade negotiations have to be conducted, allowing for trade deal contingencies akin to “pork barrel” additions to Congressional legislation. Side demands during a negotiation will only complicate the chances of achieving the meaningful trade reforms that both sides profess to want.
Ultimately, while foreign trade is important, it is not a life-and-death aspect of the current US economy. So, it would take near-complete disruption of trade flows to threaten recession in the US. Our base case belief is that all sides will pull back before we reach such a point. However, in view of recent acrimony and actions on both US-China and US-Mexico trade issues, we cannot categorically rule out such an undesirable outcome.
On the subject of whether an escalation of tariffs could translate to higher inflation in the US, Portfolio Manager John Bellows argued in a recent blog post, Tariffs and Inflation: Not Particularly Worrisome, that while the initial round of tariffs will likely raise consumer prices, its effects are unlikely to be persistent and will likely have almost no impact on Federal Reserve (Fed) policy or long-term inflation. In analyzing how prices and quantities of “major appliances” responded to the 2018 tariffs on washing machines, Bellows notes that the tariff impact was short-lived, as inflation quickly fell back to pre-tariff levels. In fact, prices declined outright in March 2019, and in doing so returned to the pre-tariff pattern, which saw six straight years of price declines. The lack of follow-through on price inflation should not be all that surprising, as the tariff increases have not been repeated (for now) and tariffs have weighed on demand. This implies that there is unlikely to be much, if any, direct impact on the bond market. The more important considerations for the bond market will be any indirect impacts of tariffs, which could stem from changes in financial conditions or changes to the global growth outlook.
On that note, recent dovish pivots by central banks globally have helped to bu.er the impact of existing tariffs and we would expect policymakers to unleash more expansionary measures if needed. So far, China has initiated a wide range of measures intended to stabilize the country’s growth momentum (e.g., reserve requirement cuts, value-added tax reductions, private sector credit programs, etc.). The Fed, the Bank of England and the Bank of Canada have all recently signaled that interest rates are likely to remain on hold while both the European Central Bank and the Bank of Japan telegraphed policy would stay accommodative for longer. More recently, the Reserve Bank of Australia cut its official interest rate to a new record low while the Reserve Bank of India delivered its third successive interest rate cut—in line with the dovish leanings observed across a growing number of emerging market (EM) central banks. We expect this supportive policy backdrop to help shore up business confidence and turn the global manufacturing cycle (led by Germany and China) that has been softening since early 2018 (Exhibit 2).
Exhibit 2: The Global Manufacturing Cycle
Exhibit 3: How the Trade War Has Played Out
Exhibit 4: After Evidence of Weaker European Growth Earlier This Year, the Overall Outlook Is Now Improving
While itself less significant than a US-China resolution, the completion of the USMCA would have helped business confidence and helped to avoid what could be a potential hit to Canada and Mexico. However, the surprise tariff threat against Mexico increases the uncertainty regarding a near-term ratification of the USMCA. It comes at a time when the Mexican and Canadian governments are presenting the USMCA to their governing bodies for ratification, and in advance of a push here in the US to consummate the deal.
Exhibit 5: Industry Impact Across Key Trading Partners
The View from the Frontline
Exhibit 6: Summary of Trade War Impact Across Global Credit Scores
Staying Optimistic, Yet Cautious
Exhibit 7: YTD 2019 Excess Returns
In this fragile environment, our sector teams globally remain vigilant in monitoring industry developments, revenue and margin trends, management sentiment, and valuations, then revise our opinions accordingly. Any changes of opinion in the face of trade war-related risks remains driven very much by individual issuer views—the better diversified a company is geographically, by segment and in terms of supply chains, the more scope it has to address trade threats.
Based on our top-down view and bottom-up assessments of trade war risk, our broad market and dedicated investment-grade and high-yield credit portfolios are positively inclined toward banks (with an emphasis on the strongest US and European banks across the capital structure given stable to improving fundamentals, benign technicals and attractive valuations), energy (focused mainly on US oil-directed E&P as well as pipeline and midstream credits) and metals & mining (principally copper-related names based on the fundamental backdrop)—all sectors that exhibit a lower sensitivity to tariffs—complemented by a favorable opinion toward long US duration, as it remains the best diversifying hedge in a period of growing uncertainty.
"Pork barrel" is a metaphor for the appropriation of government spending for localized projects secured solely or primarily to bring money to a representative's district.
The Citigroup Economic Surprise Indices are quantitative measures of economic news defined as weighted historical standard deviations of data surprises.
Brexit refers to the departure of the United Kingdom (UK) from the European Union.
The European Central Bank (ECB) is the central bank for the Euroean Union.
OEM, or original equipment manufacturer, refers to companies building replacement parts for products already in the marketplace.
West Texas Intermediate (WTI), also known as Texas light sweet, is a grade of crude oil used as a benchmark in oil pricing.
A Commercial Mortgage-Backed Securities (CMBS) is a type of mortgage-backed security that is secured by the loan on a commercial property.
A Mortgage-Backed Security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages.
Investment-grade (IG) bonds are those rated Aaa, Aa, A and Baa by Moody’s Investors Service and AAA, AA, A and BBB by Standard & Poor’s Ratings Service, or that have an equivalent rating by a nationally recognized statistical rating organization or are determined by the manager to be of equivalent quality.
Emerging Market Debt, denominated in U.S. dollars
A contingent convertible bond (CoCo), also known as an enhanced capital note (ECN) is a fixed-income instrument that is convertible into equity if a pre-specified trigger event occurs. The concept of CoCo has been particularly discussed in the context of crisis management in the European banking industry.
Purchasing Managers Indexes (PMI) measure the manufacturing and services sectors in an economy, based on survey data collected from a representative panel of manufacturing and services firms.
A credit spread is the difference in yield between two different types of fixed income securities with similar maturities, where the spread is due to a difference in creditworthiness.
The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
Emerging markets (EM) are nations with social or business activity in the process of rapid growth and industrialization. These nations are sometimes also referred to as developing or less developed countries.
Cross Domestic Product ("GDP") is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.
The Agreement between the United States of America, the United Mexican States, and Canada is a signed but not ratified free trade agreement between Canada, Mexico, and the United States. It is referred to differently by each signatory—in the United States, it is called the United States–Mexico–Canada Agreement (USMCA); in Canada, it is officially known as the Canada–United States–Mexico Agreement (CUSMA) in English and the Accord Canada–États-Unis–Mexique (ACEUM) in French; and in Mexico, it is called the Tratado entre México, Estados Unidos y Canadá (T-MEC). The agreement is sometimes referred to as "New NAFTA"in reference to the previous trilateral agreement it is meant to supersede, the North American Free Trade Agreement (NAFTA).
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