Trade War: 4 Potential Market Outcomes

Posted On July 5, 2018 10:54 am

With the U.S. set to initiate some $34 billion in tariffs on China tomorrow and the Chinese expected respond in kind 24 hours later the opening skirmish in what could spiral into a trade war is upon us.

So far, expect for a few down days that have been more hiccup than correction, the stock market has mostly shrugged off any concerns.  The belief seems to be that neither country, nor Europe, Mexico or Canada which have already imposed tariffs on some U.S. products, that agreements will be sorted out sooner than later.

But as a report from Goldman Sachs points out, in order to win the war Trump needs to show the credibility that he is willing to go the distance and hold firm to his word.  It may take a deep stock market decline to convince trading partners of Trump’s conviction.

“We do not expect the Trump Administration to be able to convince trading partners these proposals are real without also convincing financial markets,” Goldman Sachs economists wrote to clients on Tuesday night.

The investment bank warned that “further escalation seems likely” between the United States and China, although it may occur slowly but could spread quickly globally.

Here are the current tariffs in place against the U.S:

Here are four possible scenarios they see playing out.  They range from one an done to all hell breaking loose.

Scenario One: $50 billion and done. The U.S. imposes tariffs, China retaliates. Financial markets shudder. Fearing panic, both sides send reassuring messages and hold fire on further measures. In this scenario there would be a negligible impact on the U.S. economy and a maximum drag on China’s growth of just 0.2 ppt next year. A broadening of tariffs to affect $250 billion of Chinese exports could drag on China’s economic growth by up to 0.5 ppt, we estimate.

Scenario Two: $50 billion, plus a slump in financial markets. The U.S. imposes tariffs, China retaliates, equity prices fall sharply, creating a second-round effect from falling wealth and tighter financing conditions. Fearing worse, both sides hold fire. In this scenario, growth in the U.S. weakens by 0.4 ppt next year, China is mostly unscathed by the decline in equities, thanks to insulation from global markets, but the 0.2 ppt drag from tariffs remains. And the world economy experiences a roughly 0.2 ppt drag to growth as well.

Scenario Three: The U.S. imposes 10% tariffs on all imports and the rest of world retaliates. In other words — we find ourselves in a global trade war. It would take time for the biggest impacts to be felt, but in 2020 the drag on annual GDP growth might be 0.4 ppt for the U.S., 0.2 ppt for China and 0.2 ppt for the world.

Scenario Four: The U.S. imposes 10% tariffs on all imports, the rest of the world retaliates, and financial markets slump. Layering on a tightening of financial conditions might raise the peak GDP growth impact to 0.8 ppt in the U.S. and 0.4 ppt for the world. China, being insulated from world equity shocks, might escape the additional burden of tighter financial conditions.

Here is how it might play out over time and the impact to the stock market.

As noted, we seem committed to the first step and a quick China retaliation.  If financial markets don’t provide a clear ‘stop’ signal, a second could follow.

In other words, the only way this stops is if markets crash. And if markets don’t crash – anticipating Trump folding – then he will double-down on his trade tariff attacks until it does.

 Related: The Fed is Struggling With Its Balance Sheet. Here’s What You Need to Know. 

Tagged with:

About author

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.

Related Articles