On Friday, financial markets largely shrugged off — once again — signals of another escalation in trade tensions that took actual and threatened U.S. tariffs beyond the $1 trillion mark.
President Trump’s latest warning to China came on a day that saw the largest weakening of the yuan in two years — a move that could accentuate the administration’s view that China is manipulating its exchange rate to gain unfair competitive advantage.
Meanwhile, German Chancellor Merkel characterized global trade tensions as “very serious,” warning of the potential consequences for Europe and the global economy.
The continued relative market calm in the face of all this may appear baffling to some and understandably so.
{mosads}They note that President Trump’s statement that he would consider tariffs on an additional $500 billion of China’s exports to the U.S. could escalate the protectionist tit-for-tat between the world’s major economic powers, bringing the global economy closer to a full-blown trade war that would threaten recession, financial instability and heightened geopolitical tensions.
Even the U.S. — while less sensitive to damage due to the mix of agility and resilience that comes from a large and diverse economy, a broad resource base and unmatched entrepreneurship — would face a new set of headwinds at a time when the economy is building on its growth momentum.
Meanwhile, the rule-based international monetary system that has served both the U.S. and the world well would face higher risk of deep fractures.
Yet, the market calm is not so baffling given the consensus investor views on the ultimate destination for the international trade system, as well as the journey there.
Most investors believe that, rather than a full-blown trade war, current trade tensions will ultimately deliver a still free and a fairer trade system.
It’s a baseline expectation that is supported by a simple game theory analysis that shows that steps taken by the U.S. to reinforce the credibility of its protectionist threats increases the likelihood that China would eventually accede to legitimate requests regarding intellectual property rights, joint venture requirements and other asymmetrical non-tariff barriers.
This is the case for a simple reason: Facing a higher relative and absolute risk of damage — suggested already by the underperformance of Chinese stocks — it becomes in China’s interest to make concessions rather than end up in a full-blown trade war.
Markets also believe that the journey, while inevitably bumpy, could offer opportunities.
Using game theory language, it takes time for all parties to adjust to the fact that trade, an inherently cooperative game, is for now being played uncooperatively. This implies changes in strategies, assessments and behaviors. They take time and are not always implemented smoothly.
As long as markets believe that the ultimate destination will be free and fairer trade, the occasional bump is seen as both temporary and reversible and, therefore, as potentially offering buying opportunities.
But this does not mean there are no risks. The new way trade policy is being approached increases the risks of miscalculations, accidents and policy mistakes. That’s why, in addition to the baseline, markets are acutely aware of what’s called a “fat left tail” — that is, a possibility that we could end up in a damaging full-scale trade war.
It is a possibility that increases with each escalation in the tit-for-tat and with each fracture to the rule-based trade system.
Less appreciated for now is the possibility of a “right tail” — that is, a positive risk scenario that culminates in something that goes beyond a still-free but fairer trade system.
A historical parallel here is the 1980s arms race with the Soviet Union that President Ronald Reagan embarked on — and won. While both costly and risky, it was a strategy that helped redefine for more than two decades the geopolitical landscape in a manner that benefited the U.S. while reducing the global risk of traditional armed conflict between nation states.
Like President Reagan’s arms race with the USSR, the tariff tit-for-tat involves both costs and risks. Also like the arms race, it is something that the U.S. wins in relative terms (notwithstanding absolute damage in the process).
And, if well executed — and luck breaks in the United States’ favor — it opens the possibility of redefining the global trade landscape. As a small but important illustration, Germany and the U.S. are now considering a zero-tariff car initiative that, not so long ago, would have been seen as unlikely if not unthinkable
The immediate implications of all of this are three-fold.
First, there is nothing irrational about why markets have remained relatively calm in the face of escalating trade tensions. It reflects concurrent assessments of relative economic strengths and what ultimately makes sense for the parties involved (namely, a return to a cooperative game for trade).
Second, this is not the outcome of a single consensus expectation but, instead, a distribution of potential outcomes that includes tails. Third, the distribution is subject to continuous update in view of new information and analyses.
As to how I view things currently, I would assign a probability of 55 percent to the markets’ baseline, 30 percent to the left tail of a full-blown trade war and 15 percent to the right tail of a “Reagan Moment” for international trade.
These are probabilities that are subject to continuous review, especially given the unpredictability and the inherent complexity of protectionism; and they also highlight the importance of calm and calculated strategies on all side.
From a U.S. perspective, the probability distribution could be shifted in a more positive direction by the administration working more closely with allies to form a coalition to fix what ails the global trade system, by pursuing more of the negotiations with China behind closed doors and by working with Congress to extend economic initiatives at home that strengthen a domestic growth momentum that is already outpacing most other advanced countries.
Mohamed El-Erian is the chief economic adviser of Allianz and former CEO of PIMCO. He is a frequent guest on CNBC and a contributing editor to the Financial Times. He has written two New York Times Best Sellers: “The Only Game in Town: Central Banks, Instability,” and “Avoiding the Next Collapse.”