The escalating trade war between the US and China has the potential to knock the global economy into recession while wiping three years of returns off the stock market, Pictet Asset Management strategists have warned.
After a few months of relative calm, the US-China trade tensions have jumped back to the forefront of investors’ minds and sparked more volatility in the world’s stock markets.
Earlier this month, US president Donald Trump announced that tariffs on $200bn of Chinese goods would be increased from 10 per cent to 25 per cent.
China then retaliated by saying it will raise tariffs on $60bn of US goods.
Fund managers’ biggest tail risks
Source: Bank of America Merrill Lynch Global Fund Manager Survey, May 2019
In their latest update, Pictet Asset Management chief strategist Luca Paolini and chief economist Patrick Zweifel argued that “when trade breaks down, everybody loses” and said investors should brace themselves for “some fallout” from the tit-for-tat measures between the two countries. But they warn that more escalation could have serious consequences.
Analysis by Pictet on the impact of a full-scale trade war between the world's largest and second largest economies makes for sobering reading.
The group’s models suggest that this would have the potential to tip the global economy into a recession. If a 10 per cent tariff on US trade were fully passed onto the consumer, then global inflation would rise by about 0.7 percentage points; this in turn could reduce corporate earnings by 2.5 per cent and push back 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. This, in effect, would turn the clock back on the world stock market by three years. US bond yields may fall, but the scale of decline will be limited due to an inflationary impact from tariffs,” Paolini and Zweifel said.
“Washington and Beijing may still be able to reach a deal at the June G-20 meeting. But should they fail, the planned tariff increases would cause both economies to suffer: we estimate that existing trade measures would reduce China’s growth by 0.5 per cent and the US’s by some 0.2 per cent.”
In addition, the strategists argued that the impact of a full US-China trade war would be felt “far beyond” these two countries.
Indeed, as the chart below suggests, open economies such as Singapore and Taiwan in Asia and Hungary, the Czech Republic and Ireland in Europe might be more vulnerable to the trade war’s fallout than the US and China.
Global value chains participation rate*, % share in total exports
Source: Pictet Asset Management, CEIC, Refinitiv. *Participation rate is defined by WTO as foreign value-added content of a country's exports + value added supplied to other countries' exports
When trade tensions rattled markets in 2018, the US stock market outperformed China and most other countries. However, Paolini and Zweifel said that – “contrary to conventional wisdom” – they expect Wall Street to suffer more from an escalation in the trade war than its international peers.
“This is because the US is the most expensive market in our valuation model and its sector composition is more sensitive to changes in economic conditions. On a 2019 price to earnings basis, the US market trades about 30 per cent higher than its European, Japanese and emerging market counterparts,” they explained.
“Cyclical stocks, and, in particular, expensive sectors like consumer discretionary and IT will probably suffer the most, while shares of Chinese exporters should also come under pressure.”
What’s more, investors should not hold out too much hope that the Federal Reserve would provide any additional support over what is already expected.
Markets have already priced in a 25 basis point interest rate cut by the end of this year, even thought the Fed’s officials are not expected to make any moves for the rest of 2019.
“The picture that emerges from our analysis is similar to what investors have previously experienced,” Paolini and Zweifel concluded.
“The history of financial markets shows that the erection of trade barriers is bad for equity markets: the S&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.
“As experience unequivocally shows, no-one wins a trade war.”
Pictet Asset Management is currently underweight equities, with overweights to the UK, emerging markets and Asia-Pacific ex Japan stocks. It is neutral Europe and Japan but underweight the US.
It remains neutral on bonds and overweight more defensive assets like cash and gold.