Credit markets (relatively) calm
Q: Which economy stands to be hurt the most if the trade war drags out or escalates?
While White House economic adviser Larry Kudlow acknowledged “both sides will suffer,” it likely would be in different ways. We think the direct impact on China would be greater, especially if the conflict accelerates to a full-blown trade war with 25% tariffs imposed on nearly all bilaterally traded goods. For one, China’s economy is smaller. But it also has a large trade surplus with the U.S. and relies heavily on exports. In contrast, while tariffs might seem manageable for the U.S., an outright trade war—especially a multilateral one with China, Europe and other countries—eventually could lead to a broader economic slowdown that would be far more painful. Business and consumer confidence would probably plummet, financial conditions would likely tighten and market volatility would almost certainly rise—all of which could result in substantial declines in demand, output and employment. How each country navigates the situation also is significant. Chinese policymakers likely would step up quickly to stabilize growth and boost confidence, while the U.S. and Europe may have less policy flexibility.
Q: We’ve seen equities sell off, but how have the credit markets reacted?
Credit markets have responded in typical risk-off fashion, but the market moves have been relatively modest so far. U.S. credit spreads are obviously wider this month, but nowhere near the widening seen in late 2018. Perhaps many investors still expect cooler heads will prevail and the worst will be avoided. Another major reason is that the Federal Reserve has turned dovish and might make a precautionary rate cut in case of a trade war to stabilize growth and financial markets. The situation is highly uncertain and fluid, and we think the best course is to stay close to home. So we are positioning our portfolios with a neutral duration call, a modest overweight to spread products and an expectation that the yield curve will steepen. In fact, we think the yield curve is likely to steepen whether or not a deal gets done.
Q: What do you believe will be the ultimate resolution between the two countries?
It may be wishful thinking, but I am optimistic that rationality will prevail and a trade agreement will be reached. The cost of a trade war is simply too enormous for both sides and for the global economy. The world’s two biggest economies are deeply intertwined in ways that make a trade war unsustainable. However, the road to get there will be bumpy. Recent economic and market strength in both countries has reduced the incentive to compromise. With the 2020 presidential election still some time away, President Trump can afford a few months of tensions in hope of extracting more concessions. Even when a deal is finally reached, I expect frequent trade skirmishes to become the norm, with most related to compliance with the agreement. More broadly, as China’s economy grows, U.S.-China relations may be driven by deeper competitive dynamics in various areas, intensifying strategic competition.