Markets have taken trade conflicts in stride — for now

If President Donald Trump’s aggressive policy of picking trade fights with allies and adversaries alike is so bad, why are markets taking it in stride? Should we conclude that the policies are tamer than commonly believed? Or is the lesson that markets are overly complacent?

A first question is just how complacent U.S. equity markets have been. While President Trump nixed the Trans-Pacific Partnership (TPP) and threatened to end the North American Free Trade Agreement (NAFTA) in 2017, his first unorthodox trade action came on Jan. 22, when he approved “safeguard” protection for washing machines and solar panels. On the eve of that action, the S&P 500 closed just around 2,810, roughly where it trades today.

{mosads}What should markets have done? It is worth keeping in mind that there were two strong stimuli pushing on markets. Over the first half of this year, the nominal federal funds rate — a baseline for short-term interest rates — ranged between 1.4 and 1.8 percent.

At the same time, inflation expectations were, by one measure, greater than 2.5 percent (annual). That meant that real interest rates — after adjusting for inflation — were negative. That would normally provide a strong stimulus to all sorts of investment, including in stocks.

Further, heading into the year, President Trump had just signed a large tax cut with official forecasts of dramatic deficit spending. That should have resulted in upgraded estimates of corporate investment and profits, thereby driving further stock gains (though those gains may have occurred in anticipation in 2017).

This then counts as an argument against complacency. Without the trade headwinds, one might have expected even stronger stock market performance.

Turning to the economic effect of a trade war, the issue can be broken into two parts: Would a trade war be a big deal? And how likely are we to actually have to endure a trade war?

There are a few arguments out there that suggest taking the trade measures in stride. First, there is the argument that trade actually accounts for a limited share of U.S. GDP: Imports were just under 15 percent and exports just over 12 percent.

Second, only a small fraction of that trade is currently subject to new trade restrictions. Third, if trade restrictions are so bad, why have we not seen effects in the data? So how bad can things be?

There are a couple of problems with these arguments. The most important is that modern manufacturing makes use of global supply chains. A good such as an iPhone or a car is made in multiple countries, with parts and partial-assemblies crossing back and forth across borders.

If one knocks out 15 percent of a global supply chain, it is not a 15 percent reduction in output, it’s 100 percent — the good is missing a key part. This, in fact, is what happened when Japan suffered its Fukushima disaster in 2011 — U.S. factories that relied on parts from the region ground to a halt.

As to why we have not yet seen effects, it is worth remembering that President Trump only “went big” with tariffs in the beginning of June, when he surprised most analysts by failing to roll over steel and aluminum tariff exclusions for Canada, Mexico and Japan.

Given that firms have stockpiles of inputs and pre-existing contracts, that does not leave much time for effects to be felt. The China tariffs — and subsequent retaliation — came even more recently on July 6.

The other key question about the trade war is whether or not it will be short-lived and resolve to a world of more open markets or whether we are seeing the start of ongoing commercial conflict. This seems to be the dimension in which markets are misreading the Trump team most severely.

There has been a persistent belief that either the president’s trade threats are empty rhetoric or that the threats will lead quickly to a beneficial resolution.

There is no evidence to support this optimism. On steel and aluminum, the administration’s only proposed resolution for countries such as South Korea has been to adopt perpetual protection. On NAFTA, the administration has blocked the agreement with impossible demands, such as for a “sunset clause.”

With China, the Trump administration has repeatedly struck agreements and then abandoned them, leaving the Chinese with little idea whom they can talk to, nor much idea what actions could resolve the conflict. In most of the conflicts, there are not even ongoing talks.

The Trump administration has also announced plans to dramatically expand its protection to autos and hundreds of billions  more in Chinese imports, perhaps as soon as next month.

If the strong tailwinds of interest rates and fiscal stimulus subside, if supply chains are interrupted and if the Trump administration carries through with its stated plans, the economic effects could be significant and markets could be in for a rude awakening.

Philip I. Levy is an adjunct professor of strategy at the Kellogg School of Management and a senior fellow on the global economy at The Chicago Council on Global Affairs.