US President Donald Trump has been relatively subdued over the last few months when it comes to trade, a period that roughly overlaps with the time it took to pass tax reform. He was under pressure to keep quiet about it during the tax negotiations, but 2018 is likely to bring a very different Trump. This “economic nationalism” stuff is not just talk. Trump is a true believer in protectionism, and I suspect we will soon see tweets about tariffs.
Let’s assume that most people in finance are in agreement about the benefits of globalization and free trade, which have led to a disinflationary boom and an increase in the standard of living of pretty much everyone, except manufacturing workers in developed countries, who stand out as the biggest losers. In a global market for labor, they were simply uncompetitive. That’s not their fault. But the tragedy here is that some people have begun to oppose free trade under the principle that it is unfair, a view that emerging-market nations surely oppose.
And yet, financial markets have started 2018 the same way they ended 2017, with broad strength across a wide range of asset classes. I can’t be the first to notice that 2018 could be the year that we get an honest-to-goodness trade war and central banks pull back from emergency monetary policy measures. What I mean is that there has been speculation the European Central Bank will start to taper its asset purchases in a meaningful way. There’s little doubt that the ECB’s commitment to do “whatever it takes” to preserve the European Monetary Union has been the single most distortive policy in the modern history of central banks, driving yields on even low-quality junk bonds to negligible levels.
I would characterize an ECB exit from quantitative easing measures as probable, and I would also say people are underestimating the likelihood of monetary tightening in Japan, where there is a high risk of a financial accident. The Bank of Japan owns about 70 percent of the nation’s market for exchange-traded funds, which translates into a big chunk of the stock market. They’ve bought so much sovereign debt that the government bond market has effectively ceased to function. There has even been open discussion among analysts of the BOJ actually cancelling government debt, leading to trillions in printed yen remaining in circulation.
So, although it’s not hard to make a bearish statement about the stock market, those who have made such pronouncements in recent years look pretty foolish. But it’s an axiom of equities that you want to be bullish when central banks are adding liquidity and bearish when they are withdrawing it. The Federal Reserve is gradually stepping back from a very long period of negative real interest rates and has started to shrink its $4.5 trillion balance sheet. If all goes according to plan, the target federal funds rate will be above 2 percent at the end of the year. At some point, higher rates are going to bite.
As for Trump, if he initiates tariffs against China on things such as steel and aluminum, and China retaliates, and the US retaliates back, leading to a full-blown trade war, there should be little academic argument that this is going to substantially reduce global GDP. It will be hard on the US, but it will be especially hard on emerging markets.
But if globalization caused deflation in the price of manufactured goods -- think $300 television sets at Wal-Mart -- a trade war will cause inflation -- lots of inflation. Economists have lamented the fact that incomes have been stagnant over the past two decades, but the reality is that people’s standard of living is pretty high because their dollar goes much farther. Things are cheap -- things like silverware and lamps and toys and baseball gloves and dishwashers. It’s been a long time since things were expensive. We have forgotten what it was like.
I have a reputation as a bit of a bear, but these twin risks of trade and liquidity are pretty huge risks. And that’s not to mention the risk of an actual nuclear war, which the stock market seems to almost find humorous. Starting a trade war would be an extraordinarily bad decision. Removing monetary policy accommodation would be an extraordinarily good decision. If both happened at the same time, 2018 could be an interesting year.
Bloomberg View
