How To Defend Your Portfolio From The Trade War Crossfire

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How To Defend Your Portfolio From The Trade War Crossfire

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What Is A Trade War?

The steel in play might not be guns and tanks, but a trade war hurts no less. Inflicting economic pain on rivals is a classic tactic in global politics, and it’s becoming increasingly popular. We’ve wrangled these intercontinental bust-ups into five bite-size sessions for you in this Pack. En garde

What is trade good for? No country is the best at making every product – whether it’s down to their natural resources or cultural priorities, some countries are just better at doing some things than others. When two nations trade, their economies each take up partial residence in their neighbor’s domain – and it starts to make sense to think of an overall global economy across nations. By letting each country focus on what they’re best at in the supply chain, international trade efficiently maximizes overall production and can send global growth sky-rocketing. Since everyone can contribute their comparative advantages, much of the world favors a mostly free trading system today.

So why have a trade war? Unfortunately, things aren’t always peachy – especially if a “fair” slice of that global growth doesn’t reach your nation. Countries have lots of reasons to dislike each other: whether it’s unfair business practices, security concerns, or immigration disputes. When actual violence might seem excessive, economic vandalism can be a balm for sore feelings – a way to punish a country for its behavior and try to force change. When your government imposes a tariff on imports from naughty neighbors, it’s taxing their goods when they enter your country (which jacks up prices, threatening to turn away price-conscious consumers). And sanctions on people, corporations, or whole nations can forbid your companies from doing business with theirs, and tank their economy.

But the country receiving the spanking rarely takes it lying down, and usually throws its toys out of the pram with retaliatory tariffs and sanctions of its own. And that tit-for-tat can quickly escalate a small dispute into an all-out trade war.

President Trump started a US-China trade war because he thought their trade was unfair in China’s favor, and that the US could do better if it were willing to flex its muscle and insist. America doesn’t want to put up with the Chinese penchant for “stealing” American firms’ inventions while also making it hard for outsiders to share in China’s rise. And it’s concerned about the “trade deficit”: America buys vastly more from China than the Chinese buy from the United States. In slapping tariffs and other sanctions on China, the American government has two motives: it wants to bring manufacturing jobs back to America, and it wants to pressure the Chinese leadership to agree a “fairer” deal – one that’s better for the US.

There’s political disagreement on what to do about these shenanigans, but since Trump blames Chinese trade policies for the current state of affairs, he sees it as just a matter of him getting China to change course. But as we’ll see, tariffs can backfire on the imposer too...

Isn’t this mutually assured destitution? A standard defense is to retaliate in kind with your own tariffs. If the impacted country thinks it can withstand the pain of a trade war for longer than the aggressor, it might knuckle down and wait for the phone to ring with a peace offer. That strategy might work, but it’s like a game of chicken: sit tight until somebody blinks…

Until somebody does surrender, the raging battle can still blow a hole in your wallet. Our Pack will guide you through how trade disputes affect business, nations, and the global economy. So how do trade wars kick off?

What Tariffs Do

What are the initial effects of a trade war? Tariffs are usually the first bombs to drop, typically on a selection of industries. America slapped a 25% tariff on all steel imports in 2017 – a move aimed squarely at the planet’s #1 steel producer, China. Though American businesses are still allowed to buy foreign steel, they’re stuck paying 125% of the factory price, with that 25% slice going straight into Uncle Sam’s pocket.

Higher prices for foreign steel will immediately hurt big importers, but they have a few ways to respond. Raising prices on their own products could help, but that might instead cripple sales if customers refuse to pay up (more on that next session). Or they could import less, and substitute domestic steel instead. That should help domestic producers (a big motivation behind America’s tariffs).

As demand for foreign products plummets, exporters heavily reliant on sales to the war’s instigator will be particularly wounded. And the pain will spread beyond the target country: countless Chinese gadgets use Japanese components, so those Japanese suppliers will also suffer from reduced demand.

How about sanctions? Sanctions can erase a firm. When Chinese telecom giant ZTE got caught selling US tech to Iran and North Korea, Washington simply banned the rule-breaker from buying required American components, and a crippled ZTE promptly ceased its main operations in May 2018 (it was only saved by a trade negotiation).

The other big beast in China’s telecom sector, Huawei, may be next on the block. Amid spying concerns and increased trade tension, America banned its companies from exporting to Huawei in May 2019 – now Huawei will need to break open its piggy bank to develop its own operating system and chips.

But gung-ho sanctions from abroad are intensely provocative and rarely go unanswered. China provides 80% of the US’s rare earth metals – a crucial ingredient in electronics from smartphones to electric vehicles – and has publicly mooted a cut to rare earth exports that may force stockpiling and higher prices.

What’s the endgame? One goal is to address the trade deficit, growing local industry to replace imports with secure domestic production – a process called import substitution. Tariffs tend to be targeted on those specific foreign goods that the government would rather were made locally. Remember that US steel tariffs are, legally speaking, a national security measure to make sure America can build warships alone if it needs to, for example. And the risk of being economically crippled by outsiders does worry people who remember queuing at gas stations during the 1973 Oil Crisis, when oil exporting countries demonstrated their power to cut off America’s fuel supply.

Another goal is to hurt foreign exporters so much that their government has to change its trade policies to survive. But their government can instead strike back to hurt the instigator’s exporters enough to make them back down.

Trade war’s a tricky game that can easily backfire. Next, the wider economic repercussions.

How Trade War Affects Growth

How do trade wars impact the wider economy? Some businesses benefit from a trade war – namely domestic producers who would otherwise lose out to foreign exporters. But their success can come at a cost to the wider economy.

Foreign producers were cheaper and/or better than domestic competitors (otherwise everyone would have already bought local). So more orders for pricier local produce is actually confirmation that buyers now pay more than before. And further up the food chain, these higher costs will either lower profits or lead to increased end-product prices for customers (which will reduce sales). Either way, that means shrinking profits.

Smaller profits can strangle an economy: when there’s less money sloshing around to grease the wheels of capitalism, the whole machine starts to seize up. And higher prices sap our cash directly. If trade war comes to essential goods where there are simply no alternatives, consumers will be left with less money to buy other things.

But what about the domestic producers? Increased demand should deliver more money to local manufacturers and more jobs in their communities. The question is whether the money they make outstrips the money everyone else loses. If it doesn’t, there will be less cash in the economy and the trade war backfires.

Money raised from tariffs can feed back into the economy (America uses its tariff revenue to support farmers hurt by retaliatory Chinese tariffs on agricultural products). But that’s unlikely to be perfectly efficient – and the government will struggle to make up for the reduced demand higher prices cause. That’s why many economists say trade war creates a deadweight loss: the economy shrinks, whether you like or not.

The US-China spat is a textbook example of this. US steel companies say they’ve added 12,800 new jobs thanks to American steel tariffs. But some economists estimate that higher steel prices cost the country a whopping $900,000 per protected steel industry job. In 2018, the increase in domestically produced US steel did offset the decline in imports, but just barely.

What happens to the target country? Its foreign exports will drop, and that can inflict a major slowdown on its economy. It won’t see any benefits from the tariffs – which might encourage retaliation. That will hit the original instigator’s exports. Chinese tariffs on Apple’s iPhone, for example, could lead to Chinese consumers getting their smartphone fix elsewhere – that would take a bite out of Apple and in turn the US economy.

So trade war can hamper economic growth and could even cause a recession...

Inflation And Interest Rates

What does all this mean for me? Because tariffs make components more costly, prices will start to rise in affected sectors. This can have knock-on effects: a truckmaker being forced to use more expensive steel may feel pressured to sell its trucks for more money, so big vehicle purchasers (like shipping and logistics firms) will charge more for deliveries. The grocery stores that now have to pay more to stock their shelves won’t be shy to charge you more for your weekly shop.

There’s evidence that inflation – which measures how quickly the price of stuff in an economy increases – is already creeping into the US as tariff-impacted products like furniture and cars see prices shoot up. Prices even rose for household goods that had avoided direct tariffs – twice as fast as in the year before the trade war kicked off.

Increased inflation can be a problem – if prices rise too quickly, people will start spending less and the economy as a whole will slow. Central banks can try to tackle higher inflation by raising interest rates, but that can also hurt the economy by making borrowing more expensive. And if higher prices and retaliatory tariffs reduce the demand for exports, that could hurt currency values – making imports more expensive (because a dollar can’t buy as many euros or yen), and slowing down the economy further (more on how a shift in currency values can affect your investments in our Currency Trading Pack).

Central banks might want to tackle an economic slowdown by reducing interest rates to encourage borrowing and stimulate the economy. But that might cause even higher inflation! In other words, trade wars put central banks in a very precarious situation – it’s hard to know what’s the right move to make.

How are non-combatant countries affected? Say a trade war leads to US car manufacturers increasing their prices, then it will cost all countries more to import them. That drain could slow down their economies – and the reduced demand from that could hurt the nations they buy from. In a globalized economy, trade wars can spiral out of control pretty quickly – which is one reason why most economists can’t stand them.

But whether they like it or not, trade wars aren’t going away. Now, we’ll look at countries’ increasing thirst for bellicose rhetoric…

Is War On The Rise?

Are trade wars becoming more common? Yes they are. America isn’t just waging a trade war against China: US steel tariffs have hit the European Union and Canada too. In June 2019, the US government threatened tariffs on Mexico to pressure it into strengthening its border security, and stripped India of preferential access to the American market. Plus the US is threatening even more tariffs against the EU and Japan, and it also withdrew from a major trade agreement with Asian and Australasian countries (originally known as the Trans-Pacific Partnership).

This is part of a trend of increasing economic protectionism: rather than cooperate with each other, many countries are closing themselves off – putting the focus on domestic production. America isn’t the only country throwing up barriers: the UK is about to leave the EU, one of the biggest free-trade areas in the world, and big political movements in France and Italy call for Frexit and Italexit too (forgive the terrible names!). Trade isn’t the only factor pushing countries this way – immigration and independence are key concerns too – but it’s one of them.

Why are they doing this? Protectionism may be a backlash to the globalization that has dominated economics for the past few decades. It’s argued that international trade disproportionately benefits the rich, whilst many workers lose out. The decade-long aftermath of the 2008 financial crisis has shaken many people’s faith in their economic system. There’s a longing for something new – and old protectionism promises better lives at home.

Will it work? Probably not. Protectionist policies can really harm the global economy – even if some individual workers or communities benefit from boosted domestic production, the globe as a whole (and many of its nations) will take a hit.

Tariffs are designed to make cross-border supply chains change over to more expensive domestic components. But making goods in this costly, less efficient way will reduce the amount an economy can produce. Free trade is one of the rare topics that almost all economists agree on – more tariffs equals less growth. And there are immediate risks of recession: research firm Moody’s Analytics thinks a continuously escalating trade war could trigger a US recession at the end of 2020.

Is there any hope? There could be. Economist Grace Blakely has pointed out that “free trade today is not free”. There are already loads of tariffs, subsidies, and quotas that give some industries or countries an advantage over others. But if these trade wars inflict enough pain to make countries reconsider the status quo, we could end up with a freer system than we’ve ever had.

Some regions offer a glimmer of hope. The African Continental Free Trade Area (AfCFTA – try saying that three times) has signed up 22 nations, which should boost trade inside Africa by 52% each and every year, according to the UN. And the EU has also signed a massive trade deal with Japan, covering almost a third of the global economy. Not to mention the Trans-Pacific Partnership agreement, which faced choppy waters but finally sailed through (albeit without American involvement).

So it’s not all doom and gloom. Like all weapons, trade policies can be used for good or ill: we just have to hope more people resist the dark side…

In this Guide you’ve learned:

🔹Trade wars begin when countries impose tariffs on each other to hamper trade

🔹While local producers might benefit in the instigator’s country, it’s at the expense of importers and foreign producers

🔹But higher prices can hit profits – and businesses having less to spend might reduce economic growth

🔹Driving up prices and slowing down growth tends to affect interest rates too, and can even cause a recession

🔹Economic protectionism is becoming more commonplace, but Africa and Japan are glimmers of hope for carefree trade

Now test your knowledge with our Trade War quiz.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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