Resurgent protectionism threatens both the US economy and share prices – and not just if Trump wins
Protectionism – the practice of shielding a country’s industry from foreign competition – and the prospect of a descent into a beggar-thy-neighbour global trade war is one of the biggest risks to investment returns over the next decade.
Indeed, politicians are already succumbing: according to the Global Trade Alert initiative, the number of protectionist measures enacted globally in the first four months of 2016 was three times the average number of measures passed in the same period over the last seven years.
Clearly this risk is greatest if Donald Trump wins in November – the US President can impose heavy-duty tariffs without congressional approval via at least four emergency measures. But protectionism is finding favour on the left too; Hillary Clinton could make concessions on free trade in order to consolidate support from the left-leaning Democratic caucuses and supporters centred on senators Elizabeth Warren and Bernie Sanders.
A protectionist turn for American trade policy would lower long-run expected returns on US equities due to the impediment protectionism imparts on productivity growth. But how might the economy and equity markets react in the shorter term?
Pre-empting what tariffs will be applied to which goods is a hugely speculative task, so we prefer to analyse the scenario via a “shock” increase in economic uncertainty. After all, a drastic change of trade policy would cause uncertainty over the price at which firms could sell their wares abroad, to whom they could feasibly sell them, and at what price they could purchase component parts or outsource services. The regime change would likely result in the postponement of expansion plans as well as the general belt tightening that usually accompanies uncertainty shocks.
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We define economic uncertainty by our own proprietary indicator, which uses seven different measures of economic, political and financial market conditions, followed by quantitative analysis. This analysis suggests a Trump/protectionist ascendancy could lower US GDP growth by (at least) 1 to 2 per cent in the first two years, relative to what it would have otherwise been. This means that, if GDP is expected to grow by an accumulative 4 per cent over the next 24 months, a shock to economic uncertainty would lower that expected rate of growth to just 2 to 3 per cent. On the same basis, our analysis suggests that employment would be between 0.8 and 1.5 per cent lower than the base case.
It is worth commenting on the monetary policy response. As is common practice, we include a monetary policy variable in our model, in this case the Fed Funds rate set by the central bank. In our analysis, an uncertainty shock would usually cause the Fed Funds rate to move 1 to 2 per cent lower (i.e. the central bank would cut interest rates to help cushion the blow to employment). However, today, that would mean cutting rates deep into negative territory, something that policymakers are unlikely to do.
Of course, the Fed could use so-called “extraordinary” policy tools to proxy the cushioning effect of cutting rates, most obviously QE. Such an approach has arguably done a serviceable job over the last eight years. However, with the rates on long-term government debt now so low, it is difficult to theorise how QE could be as effective today. As such, in a low-rate world, the response of GDP growth to an uncertainty shock may be significantly larger than this analysis suggests.
So how might one position for this scenario within US equity markets? Unsurprisingly, rising uncertainty is associated with a higher equity risk premium (ERP), the compensation investors demand in return for taking on the risk associated with the future earnings of listed companies. Investors are already demanding a notably higher ERP than what one would expect from the current level of uncertainty. Although this gives us some comfort, we would still expect a Trump victory to cause the ERP to increase further, lowering equity market valuations.
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At a sector level, we expect Trump/resurgent protectionism to hurt companies with a high sensitivity to economic uncertainty, a high correlation with the US business cycle, and a high proportion of earnings originating in China. Automotives and parts, general industrials, technology hardware and equipment, and electrical and electronic equipment rank poorly across all measures. US manufacturers that source many component inputs from China would also suffer, many of which are found in these industry groupings too. But immunity from Trump and protectionism does not come cheap. Sectors such as healthcare, food and drug retail, electricity, beverages and food producers are all trading above their historic valuations.
We are looking at areas that might benefit from both Democrat and Republican initiatives. Such “election hedge” baskets may consist of defence stocks, the infrastructure plays best geared into government projects and, perhaps more controversially, regional banks (Trump has discussed reinstating Glass-Steagall – banning Wall Street banks from operating on Main Street). And while Clinton is unlikely to do so – her husband was the President who repealed it – she may push through similar legislation to bring on-side the anti-Wall Street caucus centred around senator Warren.
The election is a matter of weeks away, but we all know that can be a long time in politics. And, these days, in investments too.