When it comes to trade wars, such as the tit-for-tat escalation currently being waged between the Trump administration and the rest of the world, one burning question that investors have to answer is whether the outcome of such a trade feud will be inflationary - in the form of rising consumer costs as import prices rise as corporations pass on tariffs costs to end buyers - or deflationary - as the impact of escalating tariffs eventually results in a broader economic slowdown: the answer will determine not only capital allocation and monetary policy decisions but would have sweeping economic consequences across the globe.
Now, thanks to an analysis by SocGen, we have an answer: it depends, or rather "Inflationary short term, disinflationary medium term."
To approach the problem, SocGen parsed the newsflow for keywords that are associated with inflation and linked with “trade war”-related keywords, and repeat the same exercise for disinflation/deflation.
Since March 2018, the French bank observed that the “trade war” newsflow linked to inflationary and disinflationary scenarios has been growing. This highlights the nuanced impact of the trade wars, which SocGen "expects to be inflationary in the short term, and disinflationary in the medium term."
And while there is a temporal aspect, as of late SocGen has found that the deflationary impact of the trade war has been dominating. Here's why:
The escalating tariffs war between the US and the rest of the world is disrupting global supply chains and increasing the cost of imported goods in the short term. However, it could also spell the end of the reflation story that has supported the markets since February 2016. In fact, the global growth re-synchronisation story, driven by the recovery of Europe in 2017, has already been delayed.
One place where the immediate adverse, and thus deflationary, impact of trade war is clearly visible is the decoupling of growth stories is clearly visible in the degree of underperformance of EM equities (impacted by strong outflows from EM assets) versus Nasdaq 100, both of which are generally used to leverage growth expectations.
But the clearest take on whether trade wars result in higher or lower prices, is in the bond market itself, where concerns over the growth outlook are reflected in the relative performance of long vs short duration assets. And it is here that the outperformance of long-duration sectors (defensive) versus short-duration sectors (cyclical) has been observed across the board. However, SocGen concedes, the negative sentiment could be overdone, and if pushed enough, inflation could persist longer than expected.
Ultimately, the market outcome of the trade war will be determined by China, whose economy is already slowing and where recent policy easing has indicated that Beijing is shifting its posture to one where it intends to support its economy. This is perhaps also why despite the gathering storm clouds, SocGen remains somewhat optimistic on Emerging Markets, even as the bank keeps its "overweight" rating on 10Y Treasuries:
From an asset allocation standpoint, we remain cautious but constructive on EM equities. We keep our overweight position on US Treasuries and continue to expect the 10y yield to remain strongly anchored at the 3% level in a late-stage cycle dynamic where the 10yT is increasingly contingent on neutral rate expectations. Medium term, we believe EM equities should benefit from their yield-enhancing status, as China will continue to play the role of anchor, in an environment of further monetary policy tightening in developed markets.
Of course, it's not that simple because while China has ample opportunity to further cut the RRR, or the main rate, or to ease via various short and medium-term lending facilities, or by unleashing another credit-fueled stimulus as it did in early 2016, any aggressive intervention in the economy, especially if it results in the yuan falling further, will lead to accusations of interference by the US, which then in a feedback loop could lead to even further trade war escalation, resulting in even greater slowdown.