The financial markets have become fixated on the ebb and flow in the tariff negotiations concerning the US and China and, further, on the prospect of a technology war centred on US sanctions against Huawei.
Trade wars first assumed a pivotal position in market psychology in the final quarter of 2018, when a degradation in US-China trade relations corresponded with a crash in stock markets across the world.
In recent weeks, there have been signals that the same might arise again. Former US Treasury secretary Lawrence Summers has observed that this is a puzzle because macroeconomic models indicate that the direct economic effects of tariff increases are likely to be comparatively small and assuredly not sufficient to justify such large gyrations in equity markets.
His interpretation is that the markets are not concentrated wholly on tariff effects but on the rising expectation of a considerable economic and strategic contest between the world’s two largest economies, which could develop far beyond trade in manufactured goods.
Many of the advantages to global growth that have arisen from decades of globalisation might be overturned in the worst scenarios. However, there is a substitute interpretation, which is that collapsing US markets late last year were not reacting, or indeed mainly, to trade war shocks, but to new unexpected economic developments.
This alternative is reinforced because the latest, and most dangerous, exacerbation of trade wars in early May has been attended by a moderate drop of about 6 percent in US stocks, much smaller, so far, than the meltdown last December.
The deterioration in US/China relations in May has provoked the largest spike so far in the trade uncertainty index. This makes sense, since the latest episode has involved threats of much larger US tariffs on Chinese and Mexican imports than seen last year, and also a broadening in the conflict to include direct sanctions against Huawei, the largest Chinese IT supplier.
In reply, Chinese negotiators appear to have embraced more bellicose tone than before, including veiled threats about sales of US Treasuries.
The most significant variable – tighter monetary policy – occurred because the US Federal Reserve persisted with hawkish guidance about increases in interest rates, despite worsening economic conditions, and falling markets.
The FOMC seems to have learnt an unpleasant lesson from this lapse of judgment and communication and has quickly softened its forward guidance on its policy stance as its perceptions of downside risks have evolved.
There are three conclusions to draw from this:
Markets are reacting to changing tail risks of severe outcomes not to changes in central forecasts.
The backlash of markets to trade wars is not consistent through time. The latest episode may have increased tail risks more than last year’s outbreaks of trade wars, but developed markets have reacted less than before.
This is principally because there has been no negative monetary shock from the Federal Reserve this time. Provided the Fed remains dovish, developed markets should withstand the trade storm better than they did last year.