Trade : The Lifeblood of the Global Economy

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1 Globally Integrated Asset Allocation Strategy - Integrating Strategic Investment Themes March 2018 Trade : The Lifeblood of the Global Economy Tariff increases will only partially reverse the post-war reduction that accompanied a vast expansion in global trade. Global trade has been slowing since 2012 led by weak investment and tariff increases which accounted for 20% of the reduction. The share of goods impacted by this round of tariff increases will likely amount to less than 2% of total global exports. But the potential for an escalation in tensions is manifest. Significant exporters, including the EM, will be hard hit. On the other hand,countries within trade agreements ex NAFTA, such as the EU, will be cushioned. Trade entrepots such as Hong Kong and Singapore could be severely damaged. Global trade is the lifeblood of economic activity. Yet since 2012 growth has fallen sharply to less than 3% per annum- half the average of the previous four decades. We do not expect this will change anytime soon, mainly as rising bond yields and the uncertainties injected by Trump s increases in aluminum and steel tariffs will discourage investment, further weighing on an anemic rate of productivity growth. The current environment is likely to be highly disruptive to countries with a high share of exports located in the emerging markets, but the US should not feel entirely comfortable either. A significant portion of its exports to China consist of agricultural goods - soya beans are the most important - which could be easily made the target of tariff increases in the event of an escalation of trade tensions. Ways trade helps growth International trade theory argues that trade impacts productivity and growth in four main ways: Through allowing specialization, with countries focusing on their areas of comparative advantage and making better use of scarce resources. By exporters learning about best practice in foreign markets and achieving economies of scale. Lowering the prices of goods via cheaper imports increases real incomes. The best example of this is probably the decline in the price of electronic goods in the U.S. over the last three decades such as TV sets. This benefited those on low incomes whose purchasing power would have been otherwise substantially eroded by stagnant real incomes. And increasing the variety of products that are available. Enabling consumers to benefit from higher choice enhances welfare. In practice, producers can use advertising to create a comparative advantage as it is the attributes of the goods rather than the goods themselves which are sought after. And countries frequently apply non-tariff and import quota restrictions that can also disrupt trade but which are difficult to measure. 1

2 Customs delays, internal rules for valuing goods and the exemption of goods which are in the national security interest from referral to the WTO in trade disputes have also been used extensively. Distribution of gains is unequal All told, though, there can be little doubt that limiting tariffs and locating industry in the lowest cost points of production increases global growth. The problem is that the distribution of gains is unequal, and free trade adversely impacts low value-added competing industries in the developed world and particularly low skilled workers. The benefits, in contrast are far more diffuse and difficult to quantify. This makes free trade an easy target for the forces of populism. The consequences of tariffs So what impact will the increase in tariffs have on the global outlook given what an easy political target international trade has become? The OECD has estimated that a $1 dollar increase in tariff revenues leads to a $2.16 drop in total export earnings growth and a $0.73 drop in global economic growth. Nevertheless, while disrupting trade is indisputably harmful to global growth, there are several nuances that need to be made in respect to some of the claims made about the prospects of a global trade war: First, the average trade-weighted tariff on industrial imports (non-agricultural) in the US is just 2% compared with a peak of 60% in the early 1930s after the Smoot Hawley increases. Globally, the average import tariff is now 2.9% compared with 34% in 1996 mainly owing to the Uruguay round which brought into existence the WTO. The impact on economic activity of the proposals made on aluminum and steel will unlikely trigger a global recession, let alone depression. Neither will U.S. monetary policy add to the burden as it did in the early 1930s initially because of the rules-based gold standard and subsequently because of a reduction in the reserves of the banking system. Second, in a digital age it will be challenging to apply tariffs to intellectual trade. The losers in the trade war are likely to be stuff rather than intellectual material such as software applications, online education, or facilitation services such as travel arrangements. More generally, services have been increasing as a fraction of global trade even among developing countries which now account for 20% of trade in services- doubling since But these mitigating factors don t mean that a further slowdown in trade won't impact productivity and growth severely. To see how this might occur it is useful to examine the recent patterns in global trade and their causes. Between 1960 and 2008 the average increase in global trade was twice that of GDP growth at over 6%. Strong investment spending, tariff reductions, growing intra-regional trade within trading blocs and technological change drove the performance. 2

3 Since then it has barely kept pace. Calculations by the IMF suggest that 80% of the decline in global trade since 2008 has been the result of weak investment which is less import-intensive than consumer spending. The role of China and India Of course, China has played an essential role in these trends and it is inevitable that the investment splurge will slow as it rebalances its economy. As urbanization gathers momentum it can be expected to prioritize consumption and the external sector will become less critical. China s share of global exports has increased to 13.2% of merchandise goods and 4.3% of services and it remains to be seen whether the other emerging market powerhouse - India - fills the void. To arrive at a market share of just 5% of merchandise exports for instance, India would need to grow its foreign earnings at over 25% per annum over the next five years, which seems highly unlikely. In these challenging times for global trade the trend in tariff rates will become even more critical. Between 1985 and 2007 there was a steady reduction in tariffs which was most pronounced between the mid-1980s and the mid-1990s when they fell by 1% per annum according to the WTO. Although the trend subsequently lost momentum, tariffs still declined by an average 0.5% per annum until the Great Recession. Since then the trend has entirely reversed with tariffs increasing by 1% per annum, which the IMF estimates were responsible for the other 20% decline in the global trade growth rate. How bad will it get? So how is the current trade dispute likely to play in shaping the global outlook over the next five years? In part, the question is unanswerable because of game theory. For example, the initial response to Trump s tariffs by the EU is to propose retaliatory measures on $3.5 billion of U.S. goods ranging from clothing to bourbon which amounts to just $3.5 billion out of a total $283.5 billion of earnings from Europe last year. But whether this escalates is challenging to gauge. Equally, difficult to quantify is how damaging renegotiation of the NAFTA agreement will be for Canada and Mexico. The investment consequences With global growth already slowing after its recent mini-boom and monetary policy tightening, the psychological impact of Trump s tariff increases alone can be expected to crimp investment, and with it, productivity. But easier to gauge than the extent of the decline will be the distribution of the impact: The entrepot centers of Hong Kong and Singapore, where exports compromise more than 100% of GDP, should be hurt badly. In Hong Kong s case, the link to the U.S. dollar can be expected to exacerbate the uncertainty. Tightening Fed policy policy will directly impact an economy already struggling with an overheated property market and recent capital outflows which have put pressure on the Hong Kong dollar. The ratio of exports to GDP at 201.6% is also higher than Singapore at 176.6%, so we would recommend overweighting Singapore versus Hong Kong (see Tilt Note). 3

4 Generally, emerging markets are likely to be worse hit than the developed world, with higher export to GDP ratios and lower value-added export mix. By region Asia would seem more vulnerable than Latin America, with commodity producing countries like Malaysia especially exposed. By sector, commodities are likely to continue to be easy targets beyond aluminum and steel. This would argue for exposure to non-commodity producing countries in the emerging world at the expense of the commodity producers. To put a framework around this configuration we have constructed a basket of indices consisting of countries with a heavy exposure to global trade. We have weighted their importance in the index by the ratio of exports to GDP. Our recommendation is to short the index against the MSCI World. There are of course areas we have not focused on including how tariffs might disrupt global supply chains. This could hurt the developed world as much as the developing world. And we have purposely excluded EU member countries other than the U.K., in the belief that they will be shielded to an extent by the sanctity of their customs union. Nevertheless, we are confident we have identified the most vulnerable countries to a global trade war. Tariff Vulnerability Index Country Exports as % of GDP Weight China Hong Kong Singapore Japan UK Malaysia Turkey South Africa Chile Philippines Thailand Indonesia Canada

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