Trump's Tariffs Will Only Boost the Allure of Market Havens

(Bloomberg Opinion) -- Even before the latest turmoil in Italian politics roiled global markets on Tuesday, U.S. equities were falling and yields on 10-year Treasury securities fell back below 3 percent. What makes the moves so remarkable is that economic growth is expected to rebound in the current quarter from a slowdown in the first three months of the year, and the tax cuts passed in December are boosting corporate profits.

The recent change of heart in markets stems from a series of uncertainties relating to the Trump administration’s trade policies. In particular, the continuing threat of restrictions on imports from a wide range of trade partners will provoke retaliation affecting U.S. consumers, financial markets and activities of multinational companies. Investors should watch for the resulting volatility to discourage investments in equities and prompt demand for high-grade debt.

Market volatility this week has been driven largely by developments in Italian — and to a lesser extent, Spanish — politics. The CBOE Volatility Index, or VIX (also known as the “fear index”), surged by the most since March on Tuesday on the prospect of fresh elections as the country’s president and the populist coalition hoping to form its next government disagreed on the new finance minister. Sovereign yields and volatility declined the next day as Five Star Movement party leader Luigi Di Maio suggested that a compromise to save the government is likely.  

As Italy’s effect on the VIX index wears off, investors should expect frequent shifts in the U.S. position on trade — rather than external factors — to be the primary driver of volatility. That, in turn, should boost preference for investments that are deemed havens, such as U.S. Treasuries. As such, Treasuries rallied along with the dollar and yen early Thursday and the VIX rose as Commerce Secretary Wilbur Ross said the Trump administration is imposing tariffs on steel and aluminum imported from the European Union, Canada and Mexico to help protect America’s manufacturing base. Addressing an OECD trade forum in Paris on Wednesday, Ross said the U.S. would start imposing tariffs of 25 percent on steel and 10 percent on aluminum imported from the European Union effective June 1 at the expiry of a 30-day reprieve that Trump had extended.

The European Union said it would impose tariffs against U.S. imports in retaliation for new American duties. Measures the bloc has already indicated it would target include consumer, agricultural and steel products in many key Republican constituencies. The U.S. farming sector is highly dependent on exports and vulnerable to foreign action, more so than the overall American economy. 

Expect uncertainty and market volatility to also result on the China front. U.S. Treasury Secretary Steven Mnuchin declared on May 20 that the trade war with China was “on hold” as the two sides negotiated terms of a new agreement. But Trump put the conflict back in play with his declaration on May 29 that the U.S. would impose tariffs on $50 billion of Chinese products. He would also limit Chinese investments in the U.S. high-tech sector. The U.S. negotiating stance on China trade became more chaotic on Wednesday, as Trump trade advisor Peter Navarro called Mnuchin's comments an “unfortunate soundbite.” Navarro suggested that there had been no pause in the trade conflict, and that the U.S. is “ready for anything” in confronting Chinese retaliation on U.S. farm exports.

The tough talk may just be a negotiating tactic, but it will make investors apprehensive, forcing them to make changes to their asset allocations in response to the on-again and off-again trade wars.

Finally, talks to revise the North American Free Trade Agreement remain unresolved. The May 17 deadline that U.S. House of Representatives Speaker Paul Ryan had set for congressional approval of the treaty before the midterm elections in November has long passed. Neither Canada nor Mexico seems close to accepting a key U.S. demand on imposing a “sunset clause,” and the requirement of a minimal level of North American content for automobiles to qualify for preferential tariffs.

And it is not only the U.S. that deals with a political calendar in arriving at a new treaty with its neighbors. A populist Mexican opposition candidate enjoys a wide lead in polls ahead of the July 1 presidential elections, and has indicated that he may seek fresh negotiations if the accord arrived at by the incumbent administration does not meet his approval. A reopening of talks on Nafta would further boost market volatility and create new uncertainties.

Trade-related uncertainty should have two major effects that investors should prepare for: an increase in volatility, and enhanced attractiveness of low-risk investments.

©2018 Bloomberg L.P.

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