March 22, 2018
Peter Donisanu , Investment Strategy Analyst
Framing the Economic Implications of a Trade War
- Financial markets were rattled last week as reports suggested that Beijing could prepare trade restrictions on U.S. aerospace imports, heightening the uncertainty surrounding the potential for a trade war.
- As a result, some investors have asked whether we should be alarmed by this announcement, what it may mean to the U.S. economy, and when we would become concerned about the economic implications of a trade war.
What it may mean for investors
- In general, we believe that investors concerned about global economic growth should stay tuned to developments in the world’s largest economies and pay particular attention to tariffs targeting non-agricultural goods, such as manufactured goods.
Financial markets were rattled last Wednesday following reports suggesting that Chinese leaders could be preparing trade restrictions on imports related to the U.S. aerospace industry. The reports not only contributed to a market sell-off, but added another wrinkle to the ever-evolving uncertainty surrounding the potential for a full-blown trade war between the U.S. and its trading partners. As we noted in our March 19 Institute Alert titled “China’s Turn at the Trade War Table,” we believe that China’s trade announcement was largely symbolic and could potentially have little direct effect on U.S. exports. With the constant barrage of headlines surrounding rising tariffs and rumors of higher duties on particular goods, some investors are asking whether one product-related tariff report should be given more attention over another with respect to its influence on the global economy.
We believe that the discussion surrounding trade policy is complex and multifaceted. We also expect that the current environment is primed for a high potential of asymmetric outcomes (small actions leading to large implications). We see the probability of a full blown trade war as low at this point of time, but the risks are rising. With that said, we have made an attempt at providing a simple heuristic through which investors could frame the ongoing news about the potential for a trade war. The bottom line: we suggest that investors maintain a focus on trade policies emanating from the world’s largest economies and pay particular attention to policies that may affect aggregate high volume trade for large economy U.S. trading partners.
Countries of concern
First of all, we want to define what we mean when we say “trade war” within the context of our analysis. For the purpose of illustration throughout the rest of this report, we assume broad, symmetric policy responses from major global economies. This assumption may differ from reality and how actual events may unfold in a higher likelihood asymmetric, country by country, or region by region manner. The purpose of our report today is not to delve into all of the potential scenarios that may unfold in a trade war. Rather, we attempt to identify how the global economy may be affected by a generalized move away from open global trade toward nationalism and/or protectionism, what that means for our view on global growth, and what potential product tariffs or trade restrictions investors should monitor.
We begin our analysis by evaluating how reduced global trade stemming from a trade war might affect global economic growth (by looking at economies most sensitive to changes in international trade). To this point, we collected data on a country’s total trade as a percent of its total economic output. This gave us a standardized measure for comparing the impact of trade on various global economies. As Chart 1 illustrates, on a global basis, the U.S. and Chinese economies likely would be least sensitive to a global trade war, while countries such as Germany, Switzerland, and Singapore should be affected more so.
Chart 1. Economic sensitivity to changes in trade conditions: key economies
Sources: Wells Fargo Investment Institute, Bloomberg; March 14, 2018. GDP = gross domestic product.
While it is instructive, this understanding of an economy’s reliance on trade does not offer a clear picture of the relationship between trade sensitivity and the size of the economy in the world. For this, we look to Chart 2, which plots on two axis trade as a percent of gross domestic product, or GDP (as referenced in Chart 1) against each country’s contribution to (or weight in) the global economy. We plot this data in two separate charts to draw attention to the fact that—for the largest economies in the world (making up 90% of total output)—countries with high sensitivity to trade enjoy a smaller share of global output relative to larger economies.
Chart 2. Some of the world’s largest economies are relatively less sensitive to changes in trade conditions
Sources: Wells Fargo Investment Institute, Bloomberg; March 14, 2018. Note: Country weight as a percent of world GDP is measured in purchasing power parity (PPP) terms.
A key takeaway from Chart 2 is that countries that are more sensitive to trade tend to contribute less to overall global output—and the reverse also is true (the largest economies tend to have less sensitivity to trade). Does the fact that some of the largest economies have the lowest sensitivities to trade mean that investors should not be worried about the impact on of a potential trade war on global GDP and global economic growth? Not necessarily.
Chart 3 illustrates that the top destination for the world’s exports include both the world’s largest economies and also smaller economies like Canada, Mexico, and South Korea. In fact, much of the trade that occurs for these economies takes place among the largest players (Chart 4). Thus, a primary conclusion here is that investors should pay more attention to the developments occurring in the world’s largest economies and their key trading partners.
Oranges, bourbon, or aircraft?
Now that we have identified a generalized approach for framing countries of focus in our trade war discussion, what specific tariffs and products should we be concerned about? Could they be oranges, bourbon, or aircraft—or other goods? In some cases, reports of higher duties on these products represent a small fraction of intercountry commerce and overall global trade. For example, aerospace exports to China accounted for less than 1% of total U.S. exports in 2017. This means that, from a trade perspective, the U.S. economy is less likely to face a large growth impact if China were to move forward with punitive trade restrictions on aerospace imports. This does not minimize the potential for lost U.S. jobs or reduced corporate earnings, but it draws our attention back to the big picture and potential asymmetric risks.
Sources: Wells Fargo Investment Institute, World Trade Organization; March 14, 2018.
To this point, we went deeper in our large country analysis and paid particular attention to the exports and imports of these countries and their trading partners. Chart 5 summarizes two key points of interest: 1) non-agricultural (or manufactured) goods account for a larger share of exports and imports than agriculture does, and 2) a few, reoccurring items came in as top exports for these large economies, namely automobiles and auto parts, electronics, petroleum products, and electronics and machinery. Reports signaling the intent of one of the world’s largest trading partners toward increasing tariffs on these product categories would prompt increased focus from us.
The bottom line
While reports on the potential for high-profile tariffs continue to attract headlines and move markets at times, we believe that investors who are concerned about the impact of a potential trade war on global economic growth should remain focused on developments in the world’s largest economies and pay particular attention to tariffs targeting non-agricultural (mainly manufactured) goods. To this end, growth-sensitive trade policies are likely to center on discussions emanating from the European Union, the U.S., China, Japan, Mexico, and Canada—as these are all key trading partners for the world’s largest economies. At the same time, we would become increasingly concerned if policies were enacted by these large economies that specifically targeted trade in automobiles and auto parts, electronics, petroleum products, and electronics and machinery.
For now, we believe that the risks of a full-blown trade war remain contained and are largely dependent on actions taken by the Trump administration in the U.S. We believe that President Trump likely used tariffs on steel and aluminum partly as a means to encourage Canada and Mexico to speed up efforts on NAFTA (North American Free Trade Agreement) negotiations (the tariffs also were aimed at U.S. imports of Chinese steel and aluminum). In conclusion, we believe that global growth will continue to expand broadly around the world in 2018. As we have noted, we would become more concerned about a trade war and a slower-than-expected economic growth rate if we were to see the governments of the largest trading economies beginning to impose rounds of tariffs on their largest trade categories, including automobiles and auto parts, electronics, petroleum products, and electronics and machinery.
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