Trade conflict: Moving from rhetoric to reality?

Markets have been buffeted by the fast-developing trade conflict over recent weeks, with investors facing whiplash as the US and China alternated between threats and hints of compromise and moderation. The US is now negotiating trade on three fronts as it attempts to extract terms from China, the EU, and its NAFTA partners.

Much of the more heated exchanges look like negotiating tactics, and we think cooler heads can prevail and agreements can be reached. Meanwhile, the global economic backdrop remains positive, with the US heading for 4% annualized growth in the second quarter and earnings growth of 19% for 2018. But we need to remain alert for indications that the trade conflict is moving from rhetoric to reality, and/or starting to take a toll on the economy and earnings. Here is what we will be looking for: 

1. The direct cost of tariffs

Taxes on trade have a direct effect on corporate profits. Unless President Trump changes course, a 25% US tariff will go into effect on USD 34bn of Chinese goods on 6 July, with an additional USD 16bn of imports under review. China has already announced proportionate retaliation. Even assuming the entire burden of these tariffs falls exclusively on S&P 500 firms (an aggressive assumption because suppliers and customers would likely share in the burden), we would expect a hit to profits of around USD 25bn, about 2.0% of the index's USD 1,300bn of earnings. With earnings on track to grow close to 20% this year, this direct cost might not seem too serious. But the damage would be increased by a continued tit-for-tat cycle, with President Trump already preparing a potential tertiary round of retaliation of against China – a 10% tariff on USD 200bn of goods, and the EU warning it could levy tariffs on up to USD 294bn of US exports if the US imposes tariffs on auto imports. 

2. The indirect cost of tariffs

We are also alert for signs that the trade war is undermining business confidence, causing chief executives to delay investment or hiring. So far only a handful of firms, such as German automaker Daimler, have trimmed earnings forecasts. With the US second quarter earnings season starting in mid-July, more companies could cut earnings guidance. Signs of fading confidence could show up in capital goods orders, which have grown by an average of 7% year-on-year in the first five months of 2018, versus an average of -1% in the prior three years. Our economists will also be alert for distress in the new order component of the Purchasing Managers' surveys or for declining hiring intentions in job opening data, such as the US JOLTS. 

3. Market sentiment

Even if the damage to the global economy and profits remains manageable, a trade conflict could have a chilling effect on investor sentiment. Even the threat of action has distracted investor attention from strong economic and earnings fundamentals. Earnings per share for global companies rose 9% in the first half of the year, while the MSCI All Country World Index is flat. Worries over trade have even started to hit the tech heavy Nasdaq, which had been hitting record highs as recently as mid-June. 

Trade threats remain mostly rhetoric rather than reality.

Bottom line

Trade threats remain mostly rhetoric rather than reality, and we believe strong fundamentals can still push global stocks higher. However, we continue to monitor trade tensions, and believe it is prudent to hold counter-cyclical positions in case the risk case materializes. We are overweight 10-year US Treasuries, and the Japanese yen against the US dollar in our FX strategy, both of which should perform well if protectionism fears ramp up. Finally, investors that can implement options strategies should consider a small allocation to put option strategies on the S&P 500. 

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