Stressed out about a new trade war?

With less than two months to go until president-elect Donald Trump’s inauguration, the world braces for another trade war between the world’s largest economies. Throughout his election campaign, Trump has made it clear that one of his first acts in office will be to slap tariffs of between 10% and 25% on all products entering the United States from abroad. He claims that they will boost domestic manufacturing, create more jobs for American citizens, shrink the federal deficit, and curb illegal immigration. Yet, every time new tariffs have been announced in the past, stock markets have tanked.

We have seen this script before

When Donald Trump announced steel and aluminum tariffs on imports from all countries at the beginning of March 2018, the STOXX® USA 900 benchmark index dropped by 3.5%. When he followed this up with levies on $50-60bn worth of imports from China three weeks later, the stock market’s response was again a 4.5% correction. In mid-June of the same year, Trump declared that the US would impose a 25% tariff on $50bn of Chinese exports and threatened to apply a 10% duty on an additional $200bn if Beijing were to retaliate. The Chinese government reciprocated in kind, and US share prices lost more than 3% in two weeks. At this time, President Trump also threatened to charge 20% on automobile imports from the European Union, while the latter imposed import duties on $3bn worth of American goods in response to the steel and aluminum tariffs from earlier in the year.

Almost all of the described stock-market selloffs were accompanied by drops in US Treasury yields, as investors moved their funds into the relative safety of government debt. Figure 1 shows the total return timeseries of the STOXX® USA 900 and the 10-year US Treasury yield in 2018 and 2019. The periods of heightened trade tensions are highlighted in red.

Figure 1. US share prices versus Treasury yields (2018-2019)

Sources: ISS STOXX, SimCorp

The next escalation in the trade conflict occurred in May 2019, when the US administration raised the existing tariffs from a year earlier from 10% to 25%. The market reaction was once again a 6.5% selloff. The 25% percent import duties were then upped by another five percentage points to 30% in August, while an additional $300bn of Chinese goods were initially hit with a 10% levy, which was subsequently also raised to 15%. This again resulted in a 6% equity drawdown.

Financial markets do not like trade barriers

Despite the assertions from the incoming president that economic isolation will somehow ‘make America great again’, it should be fairly safe to assume that financial markets will not welcome the imposition of new trade barriers. Many of the large companies that dominate the US stock market rely heavily on goods and components manufactured in China or other parts of the world. Tariffs are likely to raise their input costs and narrow their profit margins.

Modeling a new trade war

Looking at some of the drawdowns observed in 2018 and 2019, a downward shock of 10% for the US stock market seems like a good starting point for a scenario analysis. And the four historical periods described above provide suitable precedents to calibrate a transitive stress test. The table in Figure 2 shows simulated returns for a range of regional stock markets, sectors, debt instruments, and exchange rates against the US Dollar, using the Axioma Risk portfolio analysis platform. All numbers are in local currency, and the bond performances were normalized to a duration of seven years.

Figure 2. Simulated returns for a 10% downward shock in US stocks

Sources: Axioma Risk

The top row in Figure 2 shows the predicted return for the US stock market. It is a slightly bigger loss than the 10% downward shock applied in the stress test, as the model regresses individual historical stock and pricing-factor returns against the timeseries of the shocked variable(s)—in this case the S&P 500 index—and then uses the resulting beta to estimate an asset’s price change.

Information technology exhibited the biggest predicted losses in three of the four scenarios. It was predominantly the manufacturers of semiconductors and gadgets in that sector, which were most adversely affected due to their strong reliance on microchips and components manufactured in East Asia. The same is true for industrial companies and producers of consumer discretionary goods. The latter contain the automobile industry, which relies heavily on free cross boarder flows of parts. This sector was hit particularly hard in the June 2018 scenario, which coincided with the threat of additional tariffs on vehicle imports from the European Union. This also explains the -16.8% loss predicted for the German stock market under that particular correlation regime.

What are the safe havens?

As noted above, each escalation of the trade conflict resulted in flight-to-quality flows, and this time is not going to be different. US Treasury bonds, British Gilts, and German Bunds are all likely to gain as yields plummet, but not all government bonds are alike. The lower or even negative returns for Italian BTPs reflects the increase in credit risk premia, which also affected high yield debt and, to some extent, investment grade corporates.

Equity sectors were also not all affected in the same way either. There appears to be a clear divide between cyclical sectors (information technology, consumer discretionary, communication services, industrials, financials, and materials), which significantly and consistently underperformed their defensive counterparts. Utilities and consumer staples, on the other hand, showed positive returns in one of the scenarios.

In the FX market, the Swiss Franc seemed to live up to its reputation as a safe haven, showing positive returns in all scenarios. The projected gains were even bigger for the Japanese Yen, though not because it is particularly safe, but because the country’s investors are extremely risk averse and tend to repatriate their funds very quickly in times of heightened uncertainty.

Markets are not pricing in the risks from a renewed trade war yet

Judging from the 5% rally of American share prices in the three weeks following Trump’s decisive victory on November 5, it seems like financial markets are not yet pricing in the risk from his planned trade policies. Yet, whenever a new round of tariffs was announced in the past, the market reaction was quick and severe. It is therefore important for portfolio managers to prepare themselves for the eventual turn for the worse. Stress tests like those discussed above can provide valuable insights on the potential impact of such adverse scenarios. Learn more about the stress testing capabilities in Axioma Risk.