Since the start of the year, risk assets have been challenged by a confluence of headwinds, including rising U.S. interest rates, European politics and moderately softening global growth. Combined, these forces have depressed market sentiment, though not materially so. The latest headwind, however, namely rising concerns of trade protectionism, presents a quantitatively different and far greater challenge for markets. That’s because: (i) there is still wide disagreement between the United States and China as to what constitutes fairer trade; and (ii) retaliation can go beyond tariffs and shift the global economy into a new era of “de-globalization.” To be sure, we still assign a low chance that today’s trade skirmish will escalate into an unraveling of global corporate supply chains. But the uncertainty surrounding that chance has clearly risen in the last few months, forcing investors to haircut their assumptions on the valuation of risk assets.
The White House’s view: a different take on globalization
To better understand the potential risk of de-globalization, it is crucial to go beyond the populist, anti-trade rhetoric dominating many of the headlines in the media. Long before Trump was elected president, the trade specialists who are now part of his administration (Peter Navarro and Robert Lighthizer) were arguing that the United States’ balance of payments and competitiveness in key technologies vis-à-vis China is unsustainable in the long run. A main premise of international trade is that different economies specialize in different sectors for which they have a comparative advantage, and in an ideal trade environment, the costs of imports should more or less be covered by export revenues. What the trade economists at the White House are arguing, in essence, is that this textbook trade idealism hasn’t happened due to unfair barriers imposed by China, such as joint-venture corporate structures, restrictions on local market access for foreign companies, and currency manipulation.
The United States’ comparative advantage is in the production of high-value-added goods and services (e.g., tech and financial services, aerospace engineering, etc.). Thus according to the textbook model, the United States’ trade balance would not get too out of whack in the long-run, because export revenues from high-value-added industries would roughly offset the revenues lost from the outsourcing of low-value-added industries (e.g., basic commodities, textiles, etc.). This is more or less what happened with respect to Europe, as the first chart above shows. The United States runs a sizeable trade deficit with Europe in low-value-added production, but 55% of that deficit is offset by an export surplus to Europe in high-value-added industries. The United States’ trade account vis-à-vis China, however, is far less balanced, as the second chart above shows. As of last year, only 15% of the U.S.’s trade deficit with China in low-value-added production was offset by a surplus in high-value-added industries. And the more progress China makes with its “Made in China 2025” plan, the more that 15% is at risk. After all, China is aiming to dominate the entire supply chain of high-value-added industries, which are the United States’ comparative advantage (e.g., robotics, aerospace equipment, biopharma).
The flipside of this huge trade deficit is that it is funded with payments of U.S. dollars and U.S. financial assets, which are nothing but claims by China on future U.S. output (first chart below). The administration sees an increasing share of foreign ownership of U.S. assets as a threat to both national and economic security. A more distant concern is that too much foreign ownership could threaten the U.S. dollar as a store of value and erode its status as the global reserve currency.
The gap is still wide—where could things escalate?
The stakes are high and the pressure on China over trade is unlikely to relent anytime soon. Economists have been focusing largely on how escalating tariffs, and the inflationary shock they may precipitate, may impact GDP growth. Their conclusion is broadly benign. They assume there are limits to this trade war, as China is not importing much from the United States and will quickly run out of items to tax. This misses the crucial point that globalization deepened the linkages between U.S. corporations and China much more than is captured in the export/import data. The bigger worry is that China could retaliate more qualitatively by limiting the production and sales of U.S. companies and their affiliates operating in China (chart above). These retaliation measures, in our view, would likely come before China decides to offload its U.S. Treasury reserves.
Said differently, we think the tail risk of de-globalization is more alarming for corporate America and financial markets than to the U.S. economy. This may sound counterintuitive, but consider that globalization greatly benefited multinational corporations by shifting production to cheaper destinations while growing sales in foreign markets, and these gains accrued significantly to shareholders. Yet these forces hardly supported U.S. economic growth, and the income gains that accrued during the era of globalization were not distributed evenly (first chart above). Given that the median worker saw stagnating inflation-adjusted wages for several decades helps to explain the backlash against globalization. From a markets perspective, the risks are high because the S&P 500 is more internationalized than ever (second chart above). At present, roughly 40% of S&P 500 profits now come from outside the United States (up from 23% in 1980, and less than 10% in 1950).
Trade tensions add to concerns around late cycle dynamics
As mentioned at the outset, we still assign a very low chance that today’s trade skirmish between the United States and China will escalate into a crisis that could materially shrink corporate America’s earnings abroad. But the uncertainty surrounding that chance is a meaningful shift for investors, and we doubt that a resolution will be found anytime soon. It is therefore prudent to assign higher risk premia broadly in financial markets, especially in the context of accelerated Fed tightening. The downside risk of further material trade escalation will likely command lower price-earnings multiples and higher credit spreads for multinational companies, especially those with significant manufacturing and sales operations in China. To be sure, we are not calling for a catastrophe in markets, but the combination of slowing earnings growth from here and high volatility surrounding trade headlines requires a more selective approach in risk markets.
Chief Markets Economist, J.P. Morgan Private Bank
Capital Markets Economist, J.P. Morgan Private Bank
Capital Markets Economist, J.P. Morgan Private Bank
Associate Markets Economist, J.P. Morgan Private Bank
BEA—Bureau of Economic Analysis
FRB—Federal Reserve Board
GDP—Gross Domestic Product
P/E— Price-earnings ratio
SITC—Standard International Trade Classifications
USITC—U.S. International Trade Commission
¹ High-value-added balance is defined as the services trade balance as well as the trade balance on SITC codes 874, 792, 776, 774. Low-value-added balance is defined as the goods trade balance excluding the aforementioned SITC codes.
² Not all companies in the S&P 500 report a breakdown between foreign and domestic profits. We assume that of those that do not report, 15% of profits come from abroad.