Trade war could boost European stock markets as the law of supply and demand plays out

Richard Harris says as the laws of economics take their course, the global economy will adjust to tariffs being the new normal and trading alliances will be reorganised

PUBLISHED : Thursday, 21 June, 2018, 1:07pm
UPDATED : Tuesday, 26 June, 2018, 3:57am

During my high school studies of economics, I used to love the beauty of its balance – strength leads to weakness, allowing weakness to move into a position of strength. 

One country gets better at trade than another; its currency rises, so its goods become more expensive to buy. People buy fewer of the strong-currency goods and more from the weak country – making the latter stronger.

It works perfectly well until politicians or businesspeople influence matters to preserve the status quo, incorrectly calling it “market failure”. The market doesn’t fail – it means that you don’t like what it is doing, a very different thing. Unbridled capitalism eventuates in monopolies, something we in Hong Kong know well.

When this happened in the US, public disquiet saw the pendulum swing with the introduction of antitrust legislation that broke up the monoliths, bringing power back to the consumer. However, incentives to encourage different behaviour usually lead to the law of unintended consequences – where you don’t know how things will work out.

US President Donald Trump’s near-term electoral fortunes rest on a policy of taxing “unfair trade”, whether with China or indeed his allies in the G7. The issues surrounding the acquisition of intellectual property and the use of non-tariff barriers on imports add extra spice to the China trade issue. Trade disputes are now both more certain and long term, and the extent to which they may affect world business has been reflected in falling share prices, as this column explained last week.

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The situation is complex. Any change in trading volume depends on the elasticity of demand for the product and on the consumer’s purchasing power. Buyers of high-end products like phones or machinery will just pay more. The losers will be low-value consumer goods. The winners include financial services that have bigger numbers to play with.

Economics will eventually lead to the negotiation of new trading treaties and tariffs will fall. One of the earliest economic concepts I learned was the law of comparative advantage – it is better to trade what you want and don’t have, than not trade at all.

It is unsurprising that the thought of tariffs makes China an unadulterated evangelist for free trade

It is unsurprising that the thought of tariffs makes China an unadulterated evangelist for free trade as the Shanghai stock market is especially exposed. The US, on the other hand, has been drugged (unintentionally) by liquidity from the Trump tax breaks – not least the repatriation of offshore-held assets, which more than counters rising interest rates. Elsewhere, conditions remain excellent for business (low inflation, low interest rates, high employment), which makes slightly higher inflation seem like a rounding error.

Some economies, such as Japan and Europe, will welcome higher inflation as a way of paring debt and expanding liquidity. China-Europe trade could take up the slack for quality products like agriculture, machinery and aircraft, but here too economics rules as the Europeans will raise their prices accordingly. Good for European exporters, bad for consumers.

The European stock markets may be a trade war winner, as company profitability gets a much-needed fillip from the shift in trade. So, too, will flabby national fiscal deficits, as governments take in stealth tariff receipts paid for by taxed consumers.

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My high school studies of the dismal science may have been simplistic but the basic principles still hold. The global economy is too interlinked to allow market imbalances to remain unchecked by political, economic or revolutionary factors forever. Trade is not being banned. Only a small proportion of it will become more expensive; it is friction, not war.

A trade war changes relationships and prices and is fundamentally unwelcome – but it is not wholly bad news

Of course, markets initially price the worst-case scenario because trade disputes between intransigent parties could conceivably drive the global economy into recession – but we should look at the most likely case, not the worst.

 Tariffs will tax economic activity but the global economy can take it. The uncertainty lies in the terms of pace and speed, and the violence and pain of change. A trade war changes relationships and prices and is fundamentally unwelcome – but it is not wholly bad news.

My base case is that we will see a slowdown on a six-month view but that tariffs will become part of the new normal; economies will adjust. Most analysts predicted a more volatile 2018 after the stock market “inflation frenzy” in February. Periodic speed bumps during times of undiluted economic growth is the way that economics saves us from the big bubble that ends in deep crisis.

Richard Harris is a veteran investment manager, banker, writer and broadcaster and financial expert witness.