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A road map for navigating protectionism: the elevator and the staircase

Investment Insight

BNP Paribas Asset Management

Trade war scenarios: tackling volatility and risk-off situations

  • Financial markets have experienced another bout of volatility, this time related to an escalation in protectionism involving the US and China. Should such tensions move towards a fully blown trade war, this would be very damaging for global economic growth and certainly for global financial markets.
  • What is at stake? Globalisation has been a key driver of increased prosperity around the world. However, not all have benefited. Some governments, notably the US government, have started to address trade imbalances as a way to support dissatisfied electorates.
  • A significant reversal in the the free movement of goods, services, labour and capital would curtail global growth and dent financial markets. But it is still unclear how far back the pendulum will swing. Institutional hurdles such as the US Congress, the World Trade Organization (WTO) and financial markets themselves may slow down, limit or even stop the current trade initiatives by the Trump administration.
  • We envisage two possible escalation scenarios.
  1. A multilateral trade war between the US and the rest of the world
  2. A bilateral trade conflict between the US and China.
  • In both cases, we should see a prolonged period of tension. Crucially, at this point, we still see full-scale trade wars as low-probability high-impact scenarios.
  • What is important for investors is how to navigate an escalation or de-escalation. For instance, an intensification could rapidly lead to sudden market moves as investors quickly reassess the probability of a trade war. Alternatively, the risks could escalate in steps, for example, if markets take the view that trade tensions may lead to tit-for-tat retaliation. In a comprehensive note, we provide signposts that should help investors assess potential shifts in markets as protectionism evolves.

Probability of trade wars can evolve in different ways: elevator versus staircase

BNPP AM probability of trade wars

  • In the note, we also delineate the likely economic impact. The combination of tariffs and quotas and a reversal of globalisation would likely lead to higher prices, lower productivity and, ultimately, lower output. We examine the likely response of central banks including how they would view possible second-round effects such as workers pushing for higher wages and higher inflation expectations.
  • We gauge the asset price implications. We look at financial market responses to oil shocks (used as proxies for supply shocks) as well as recent episodes of protectionist escalation. We conclude that equities are the asset class most at risk. The performance of other asset classes is usually mixed, suggesting that the macroeconomic and policy backdrops matter in terms of shaping market responses.
  • As for strategy, we are not altering our base-case scenario of strong growth and contained inflation. While the probability of fully blown trade wars may still be low (below 10%), we do expect further outbreaks of protectionist tension and that makes the trading environment riskier. Higher uncertainty should cause market volatility and risk premia to move higher. If the trade war scenarios remain at a low probability, it would make sense for investors to hedge investment portfolios with assets that do well in risk-off situations, but that do not underperform if these risks fail to materialise.

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