Stock markets have reasons to be jittery on trade

Financial markets have long been able to ignore the spillover from political and geopolitical developments. Now, they seem a lot more sensitive to possible disruptions these events could cause to growth and corporate earnings, and with good reason — the threats seem to be spreading and the fortifications are weaker.

Unless the possibility of a full-blown trade war turns into to an opportunity to fix long-standing defects in the global system, the defences that have proved effective in recent years risk being overwhelmed in both the financial and, more damaging, economic realms. Stock markets around the world sold off on June 25, including losses of just under 1.5 per cent for both the S&P 500 and the Dow Jones Industrial Average and of 2.1 per cent for the Nasdaq.

The downturn was a reaction to indications over the weekend that the Trump administration would consider curbs on Chinese corporate investments in US technology companies and, more broadly, could increase the scrutiny of tech exports. The harsher stance follows a period of increasing tensions that prompted China and Europe to take retaliatory steps aimed at containing and reversing tariffs imposed by the US.

Instead, the tit-for-tat measures have raised the probability of another round of protectionist measures by the US. Three main factors explain the higher sensitivity of stocks and other risk assets after a prolonged period when financial markets confidently shrugged off political and geopolitical factors.

First, many still believe that an outright global trade war is avoidable and that current tensions will prove to be part of a negotiating process resulting in fairer trade (including safeguards against intellectual property theft, the modernisation of trade arrangements and a reduction in non-trade tariffs).

Yet, undoubtedly, uncertainty and the risk of accidents have risen. Those concerns are accentuated by the recent spread of protectionist rhetoric, which now targets cross-border investment flows as well as trade.

Second, markets are no longer comforted by the narrative of a synchronised pick up in global growth. There’s good reason to be more cautious and discerning: With the notable exception of the US, growth momentum has started to weaken, and not just in Europe, where both hard and soft indicators are already under pressure. In China, the central bank announced a relaxation of reserve requirements for banks aimed at bolstering domestic economic activity.

Third, due to policy-tightening measures by the Federal Reserve and the recent absence of reassuring volatility repressing language from any of the systemically important central banks, investors have realised that financial asset prices can no longer count on the same liquidity backstops and circuit breakers, including during bouts of higher volatility.

This weakens what had been a strong and stabilising “buy-the-dip” mentality, opening up a greater possibility for technical overshoots, particularly in segments that face structural imbalances such as emerging markets.

So far, most of the discomfort caused by protectionism has been limited to financial variables and not economic ones. And the disruption has been less acute than it would be if the market decided to fully embrace a high likelihood of a global trade and investment war.

Turbulence has been contained by a belief that well-informed and rational policymaking around the world will ultimately avert an alternative that could benefit a handful of segments within countries but result in worse welfare and prosperity outcomes for all.

Let’s hope this will not prove to be more than just wishful thinking.

Mohamed El-Erian is chief economic adviser at Allianz SE, the parent company of Pimco, where he served as CEO and co-CIO.

Washington Post.