A persistent challenge of investing is identifying which issues to take seriously and which to look through. Most successful investors seem to have an almost instinctive sense of which issues the market will react to, how long they may persist, and what the market effects may be. 
Since the global financial crisis investors could be forgiven for feeling that the world has simply lurched from one cliff-edge to the next – the European sovereign debt crisis set the tone in 2011-12, the oil price slump dominated late 2014, the threat of deflation defined 2016. And the issue that could characterise 2018 looks likely to be trade.
As in any prior year there may be a plethora of bogeymen threatening market stability. Tighter US Federal Reserve policy, a rebound in the dollar, Brexit negotiations and potential instability in some emerging markets could all affect growth and sentiment; but it is the potential threat of a trade war that seems to most concern investors.
We do not expect the current trade skirmish to develop into an all-out trade war and we expect any economic impact will be limited. Nevertheless, if history is a guide the tape risk may last for some time yet. With trade an issue on several fronts – US/China, UK/EU, NAFTA, etc – even if our base case remains benign, markets will need to calibrate for the increased tail risk of an adverse outcome.
Prices in many asset markets reflect a balance between the good prevailing levels of global growth and the reality of increased tail risks. This is causing volatility and creating a headwind for asset valuations. Investors are concluding that even if the growth and earnings outlook is reasonable, they are simply not willing to pay as much for it if there is a tail risk of a prolonged trade dispute.
Thus we are left with headline risk generating day-to-day volatility and longer-term tail risks holding back asset prices, even though global growth is above trend and looks set to remain so well into next year. A further twist is that European assets seem to bear the brunt of trade disputes even if they are not directed at European countries or firms.
The most visible of trade disputes today is between the US and China. US/China trade battles are hardly a new phenomenon, but the latest one – which started with steel and aluminium before moving to other products from pacemakers to helicopters – is now intensifying, with autos in particular under scrutiny.
While there is a European angle to any threat of tariffs on cars, for many other products Europe is more of a passenger. The integrated nature of the global supply chain means that even the most targeted tariffs can have profound, if rather unpredictable second order effects. Some of these may indeed dominate the intended impact by virtue of ‘just in time’ inventory management and the drag that trade uncertainty can have on corporate confidence.
As part of an advanced economy, European firms are significantly intertwined with export partners and in many cases are upstream from China in the value chain – risking a knock-on effect from US/China tariffs even where Europe isn’t the intended target. Limitations to Europe’s bilateral negotiating framework further complicate any process to agree to tariff relief with Washington. Trade is also a key feature of the Brexit negotiations and while the UK would be at the epicentre of any breakdown in trade, both sides would suffer were it meaningfully disrupted.
For the time being the impact of Brexit-related uncertainty is limited to UK sentiment, with the currency acting as a lightning rod for evolving news flow. But ultimately, constraints to trade, whether arising indirectly from the US/China spat, or closer to home from Brexit, will affect the earnings outlook for the exporting firms that make up a big part of both eurozone and UK indices.
This leaves us with the paradox that just as Europe’s domestic economic momentum starts to reaccelerate after a lacklustre first half, European equities could continue to struggle. An improving domestic picture in Europe is likely to support the euro first and foremost.
Thus Europe’s exporter heavy equity indices could well face the twin headwinds of a strengthening currency and a prolonged global trade dispute, just as things are looking rather better back home. By contrast, the volatile Brexit negotiations which are most acutely weighing on pound sterling could indirectly offer a degree of currency relief to UK-listed exporters, in turn underpinning UK indices.
On balance, we believe the economic outlook for Europe is positive but equally recognise that with the region so intertwined in the global economy, trade and currency have a disproportionate influence on the outlook for stocks. This leaves us more cautious on European equities than our optimistic economic view might imply, and equally noting that the persistent headline risk from escalating trade tensions will keep market volatility more elevated.
Ironically, perhaps, the very country that is behind much of the escalation in trade tensions – the US – has an equity market more immune than most others to the ravages of a prolonged global trade dispute.
John Bilton is head of global multi-asset strategy at JP Morgan Asset Management. The views expressed above are his own and should not be taken as investment advice.