After months of simmering tension between the world’s two largest economies, the U.S. looks poised to impose tariffs on $34 billion worth of Chinese goods on Friday. The key question for financial markets: will it trigger fresh volatility, or is an escalation of the trade war already priced in?
The 4.3 percent rally in European carmakers on Thursday, fueled by discussions on lowering tariffs with the U.S., suggests markets had already been primed for adverse news on global trade. Yet Chinese shares remained under pressure as officials wouldn’t say whether talks that could deliver a last-minute reprieve were ongoing.
“We can no longer talk about whether a trade war will develop, only the scale of the conflict,” Steve Barrow and Jeremy Stevens at Standard Bank wrote in a note this week. “A promising global economic and financial market picture has been thrown into turmoil.”
This new era of protectionism could hardly have come at a more sensitive time for markets. While the backdrop for growth is indeed strong -- particularly in the U.S. -- financial assets were already girding for so-called quantitative tightening as the world’s major central banks step back from stimulus.
That’s siphoning liquidity from the system, and volatility is on the way back as a result. The Cboe’s Volatility Index, known as the VIX, has averaged 16.3 this year, compared with 11.1 in 2017. After recovering from a spike in February’s market blow-up, currency swings have risen for six of the past seven weeks, according to JPMorgan Chase & Co. indexes.
“Investors should expect volatility to continue,” says Mark Haefele, chief investment officer at UBS Global Wealth Management. “We recommend investors stay invested, but consider five actions: looking to alternatives, hedging equity exposure, improving credit quality, diversifying sector and country risks, and taking a longer-term view.”
The worst-case scenario is that the trade war, in concert with monetary tightening, upends the global business cycle. German Chancellor Angela Merkel raised the specter of the global financial crisis as she warned of potential fallout on Wednesday. Shares of European carmakers had fallen more than 11 percent since mid-June through yesterday.
Not everyone is buying the bearish case, particularly when taken from the U.S. point of view.
“So far the trade war dynamic has made significant headlines,” said James McAlevey, head of rates at Aviva Investors. “Fifty billion dollars writes headlines but it doesn’t move the needle on U.S. growth. If it doesn’t escalate, we don’t think it has material knock-on implications for the U.S. economy.”
Ticking Clock
U.S. stocks are outperforming amid a global slide, the dollar is near the highest in a year and Treasuries are well supported even as rates rise. Contrast that with Chinese assets -- Shanghai’s benchmark share gauge tumbled into a bear market last week, while the country’s central bank has verbally intervened to slow the yuan’s descent. Only Chinese bonds are on the up, catching a bid as domestic investors flee riskier assets.