Trade War and Peace: Which Markets Are Most At Risk

by Jeffrey Kleintop, Senior Vice President and Chief Global Investment Strategist, Charles Schwab & Co., Inc.

Key Points

• The trade measures enacted and proposed so far do not constitute a trade war, but they aren’t “trade peace” either.
• As a number of trade issues develop in the coming weeks and months, markets may remain on edge and prone to bouts of volatility.
• Escalating trade frictions on the growth of economies and companies could weigh on stocks, especially on emerging market stocks.

Global stocks gave up roughly half of their recovery from the February correction last week as President Trump previewed his plan to impose a 25% tariff on steel imports and 10% on aluminum. Not every new tariff constitutes a trade war—metals have often been a target of U.S. tariffs with steel tariffs imposed by each of Trump’s recent predecessors in the White House. Although small in economic impact, these tariffs are symbolically important. Rather than overreacting to the announced tariffs, market participants may be worrying that there is much more to come and presage a global trade war with broad negative consequences for economic growth and corporate profits. However, a trade war may not be forthcoming. After all, a lot of news stories have been written about the start of a trade war during the past year and a half, yet trade volume growth has marched steadily higher, as you can see in the chart below.

Trade war warnings haven’t slowed trade growth

Source: Charles Schwab, Bloomberg data as of 3/3/2018.

Total world trade is equivalent to more than half of the world’s economic output, according to data from the World Bank. So it is easy to see why developments that may impact the flow of the world’s goods and services across borders can have a big impact on the world economy and the earnings of global companies.

Retaliation to tariffs

The metal tariffs mark an escalation by the Trump administration relative to the modest trade actions taken so far and may provoke retaliation by impacted countries, posing further risk to the markets in the coming weeks or months.

The main focus will be on any retaliation by China. There may not be any; China has made no specific promise of retaliation to the metal tariffs. The U.S. ranks 26th on the list of countries China exports steel to. But in recent months, the Chinese press has identified potential measures the government could take in response to U.S. trade actions which include agricultural products, aircraft, technology, and even Treasury purchases.

China doesn’t even make it into the list of top ten sources of U.S. steel imports, as you can see in the chart below. Instead, Canada tops the list. Since the Trump administration is citing national security reasons, NAFTA does not provide any protection from the tariffs. It is possible that exemptions from the steel and aluminum tariffs for countries such as Canada may emerge as part of NAFTA negotiations, muting the impact and easing some market worries about the breadth of the trade measures.

U.S. steel imports: top 10 sources

Source: U.S. Commerce department. Data is year-to-date as of September 2017 (most current data available as of 3/3/3018).

Looking beyond China and Canada, there are potential retaliatory actions that may be taken by the countries that make up more than 50% of steel imports to the United States.

• Brazil, the number two steel suppler to the U.S. behind Canada, signaled that they may target U.S. coal exports. Although Brazil’s largest stock is a metals producer, making up 10% of its stock market, Brazil’s economy is in recovery and the U.S. metals tariffs by themselves are not likely to change this in our view.
• South Korea, the third largest supplier at 10% of U.S. imports, vowed to make a complaint to the World Trade Organization (WTO), but did not mention any specific retaliation. South Korea’s economy is much more tied to technology than metal production (42% of the MSCI Korea Index consists of tech companies while metal producers make up only 3%) so the economic impact should be muted limiting the likelihood of major retaliation.
• While Germany is the only European Union (EU) member nation to make the top ten, the EU nations of Germany, U.K., Sweden, Netherlands, Italy and Spain make up a combined 10% of U.S. steel imports and together account for the fourth largest supplier of U.S. imported steel. However, the metal mining companies make up less than 3% of the MSCI Europe Index. The EU, a close ally, might get an exemption from the national security tariffs. If not, leaders have vowed to file a complaint with the WTO and retaliate, primarily focusing on some select U.S. agricultural products. In addition, EU President, Jean Claude Juncker cited “tariffs on Harley Davidson, on bourbon and on blue jeans — Levi's” as potential targets of retaliation.
• Mexico supplies 9% of U.S. steel imports, rounding out the top five suppliers. Mexico has a lot riding on its trade relationship with the U.S. and we believe is most at risk of heightened trade conflict. Mexican officials indicated that they may retaliate, but haven’t specified targets. Mexico imports a wide variety of agricultural products and machinery from the United States.

Trade war losers

A key concern is that the metal tariffs may be just the opening salvo targeting countries perceived to be engaging in “unfair trading practices”, with more to come in the coming weeks. China may be a specific target, pending the outcome of the Trump administrations review of China’s alleged “theft” of U.S. intellectual property rights. This could result in tariffs, quotas, and investment restrictions. This so-called Section 301 probe could raise a much larger risk of a trade war than the metals tariffs.

If the coming weeks reveal the start of a broader trade war, the average company in the MSCI AC World Index faces significant risks to profits with more than half of sales coming from international trade. But that exposure is not evenly shared across the globe, companies in some countries and regions have more exposure to world trade than others. One way to look at what areas may be most impacted by a trade war is by trade exposure of companies that make up different countries stock markets, which you can see in the chart below.

Stock market trade exposure varies by country

Chart reflects internationally-sourced percentage of total revenue for companies in MSCI indexes. MSCI indexes include: MSCI AC World Index, MSCI China Index, MSCI Australia Index, MSCI USA Index, MSCI Japan Index, MSCI Korea Index, MSCI Canada Index, MSCI India Index, MSCI United Kingdom Index, MSCI Switzerland Index, MSCI Netherlands Index, MSCI Hong Kong Index, MSCI Spain Index, MSCI France Index, MSCI Taiwan Index, MSCI Germany Index.
Source: Charles Schwab, Factset data as of 3/3/2018.

Perhaps surprisingly, Chinese companies have relatively little international trade exposure with the vast majority of sales driven by domestic demand from the largest consumer market in the world that lies within its own borders. Companies in developed countries outside the U.S. have a greater percentage of international sales than U.S. companies. But, it is worth noting that the European companies trade a lot with each other. For example, while German companies get more than 75% of sales outside of the country, more than half of their sales are from other countries within the European Union where trade barriers among members are unlikely to rise this year. That could offset the greater international sales exposure and may actually make European companies more insulated from a trade war than their sales mix would suggest.

The equity asset class that may have the most to lose from a trade war is emerging market stocks. The performance of emerging market stocks is more sensitive to changes in global trade than developed market stocks, as you can see in the chart below. A downturn in global trade volume (usually associated with bouts of global economic weakness) has historically led to emerging market stock underperformance.

Emerging market stock relative performance moves with global trade growth

Both data series (MSCI Emerging Markets Index and MSCI World Index) are three month moving averages.
Source: Charles Schwab, Bloomberg data as of 3/3/2018.

War and peace

The market impact of escalating trade frictions on the growth of economies and companies may begin to weigh on stocks, especially on emerging market stocks. The measures enacted and proposed so far do not constitute a trade war, but they aren’t “trade peace” either. That uncertainty is likely to leave markets on edge and prone to bouts of volatility as trade issues develop in the coming weeks and months (including any tariff retaliation, intellectual property theft investigation, and both NAFTA and Brexit negotiation).

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