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Trading  | June 23, 2018

President Trump opened a new front in the global trade war on Friday when he threatened a 20% tariff on cars imported from the European Union unless Europe removes import duties and other barriers to U.S. goods, potentially endangering as much as $300 billion in commerce. Trump’s comments sent the European Autos Stocks Index sliding on Friday while shares of Ford Motor and General Motors also dropped.

“Based on the Tariffs and Trade Barriers long placed on the U.S. and it great companies and workers by the European Union, if these Tariffs and Barriers are not soon broken down and removed, we will be placing a 20% Tariff on all of their cars coming into the U.S. Build them here!” Trump tweeted on Friday.

As a reference, the US currently imposes a 2.5% tariff on imported passenger cars from the EU and a 25% tariff on imported pickup trucks, while the EU imposes a 10% tariff on all imported U.S. cars. Furthermore, in 2017, the US trade deficit with the EU on cars was about $40BN per year.

As Reuters adds, the U.S. Commerce Department has a deadline of February 2019 to investigate whether imports of automobiles and auto parts pose a risk to U.S. national security, while Commerce Secretary Wilbur Ross said on Thursday the department aimed to wrap up the probe by late July or August with the Commerce Department planning to hold two days of public comments in July on its investigation of auto imports.

Not long after Trump’s tweet, the European Union vowed it was prepared to retaliate immediately should the tariffs be imposed, saying it would continue tit-for-tat escalation in its trade dispute with the U.S. while countering Trump’s assertion that the U.S. is being treated unfairly by the 28-nation bloc.

Speaking to the French Le Monde, Jyrki Katainen, the EU commissioner in charge of jobs and growth, said that “If they decide to raise their import tariffs, we’ll have no choice, again, but to react. We don’t want to fight (over trade) in public via Twitter. We should end the escalation.”

Earlier in the week, the EU imposed retaliatory tariffs on €2.8 billion ($3.3 billion) of American products in response to duties on its metals exports deemed to be a threat to U.S. national security. According to Bloomberg, the commission, the bloc’s executive arm, said that the €1 trillion euros in commerce between the EU and U.S. is equitable, and it disputed Trump’s assertion that the EU needs to be punished because of unfair trade practices.

The U.S. had a surplus in services trade with the EU of $45 billion in 2017, according to the memo, citing U.S. statistics. The memo also said the EU is the largest investor in the U.S., accounting for 72 percent of inward foreign direct investment and that EU-headquartered firms employed 3.2 million people in the states.

All in, between trade in goods, services and primary income from investments, the U.S. runs a €12 billion surplus with the EU, according to the memo.

But beyond appealing to numbers, Europe is convinced that Trump would have no choice but to reverse direction once there is sufficient outcry from either politicians, business or if the market itself were to crash: “Members of U.S. Congress, from both parties, don’t necessarily share the views of the president, nor does the private sector,” Katainen told Le Monde. “Once the measures start making an impact, the pressure will mount.”

And speaking of the market reaction, on Friday Bloomberg macro commentator Ye Xie echoed the thoughts of Goldman Sachs from several weeks ago, according to which the market would have to slide for tariffs to become a “credible negotiating tactic”, to wit:

If tariffs are going to be used as a credible negotiating tactic to coerce concessions, then it requires a bigger financial markets selloff to make it an effective tool. After all, if investors don’t think it’s credible, how can you convince your counterparts at the negotiating table to believe it?, Goldman Sachs’ analysts argued.

That suggests that some of the tariffs may indeed have to take effect (they can always be rescinded afterwords). All that means is that there’s a greater risk for escalation in the trade dispute and a more severe market selloff.

In other words, Trump may be “in too deep” to pull back now without some significant market reaction first, which would by definition imply that one or more rounds of tariffs are likely to be imposed, which beyond merely slamming European car trade with the US, could quickly spiral into an out of control global trade war .

What does that mean for the global economy?

The answer to that question comes from Bank of America, which in turn looked at the growing trade tensions between the US and China, and wrote that “while the actual amount of tariffs that have been imposed by the US to date remain modest at just over $100bn worth of goods imports (only 4.2% of total goods imports), the latest announcement shows that trade tensions are likely to get worse before it gets better.”

While BofA’s economists caveat that the the likelihood of a full blown global trade war still remains low – although rising fast – it has modeled how a major trade confrontation could potentially impact the US economy.

Following in the footsteps of Barclays, which as we discussed last week modeled a market scenario in which the US raises a 10% uniform tariff on all good and services resulting in a 11% hit to global EPS, BofA used the Fed’s FRB/US large-scale general equilibrium macroeconomic model to quantify a global 10% tariff on all goods and services.

For simplicity, we assume a full pass-through of tariffs onto trade prices and impose 3 shocks to the model: 1) 10% import price shock 2) 10% export price shock 3) 10% appreciation in the real trade-weighted exchange rate.(*) The results are as follows:

This is what the model returned in terms of key variables including GDP growth, inflation, and monetary policy.

GDP Growth: The simulation results show a notable drag on growth (Chart 1). Annualized growth rate of real GDP declines by 0.3-0.4pp relative to baseline in the first year and shaves an additional 0.5-0.6pp in the second year before the negative impact slowly fades. This suggests that the boost to growth expected from fiscal stimulus (e.g. tax cuts and greater federal government spending) will essentially be offset by the negative trade shock. The negative growth shock leads to a 0.5pp cumulative decline in the unemployment rate relative to baseline. All told, the level of GDP at its nadir is roughly 1.2% lower than the baseline model.

Inflation: The 10% import price shock leads to a transitory pickup in core inflation. According to FRB/US, core PCE inflation accelerates modestly by about 0.1pp in the first two years before it starts to converge back to baseline. Note that the impact of higher import prices are somewhat offset by our assumption that the dollar would likely appreciate in a trade war. In a scenario where there is less response from the dollar, we would expect a greater pass-through of higher import prices to consumer prices. Nevertheless, these results are broadly consistent with our partial equilibrium inflation model based on former-Chair Yellen’s inflation model.(*) Based on this model, core PCE inflation is about 0.2pp higher in the first year of the shock before readjusting back to baseline (Chart 2).

Monetary Policy: Results from FRB/US show that, initially, the Fed would likely stay on course, maintaining its current path of policy. However, starting in year 2, the material weakening of aggregate demand should ultimately force the Fed to slow the pace of hikes by getting in roughly 2.5 fewer hikes relative to baseline, implying that the terminal rate would end up approximately 50-75bps lower at around 2.50-2.75%. The decline in the path of the fed funds rate is greater than the response in 10yr Treasuries leading to a steepening of the curve as expected by our rates strategy team.

Perhaps the most important aspect of the above, is BofA’s claim that the lagged response in monetary policy to a the potential start of a trade war is unlikely to deter the Fed from its plans to raise rates this year. As such, contrary to expectations that a trade war could spike import costs, BofA’s argument is that anything, trade wars provide a potential catalyst for the next slowdown in the economy, which incidentally would hit just as the fiscal stimulus fades.

There is one other potential unknown: how will potential uncertainty shock the system? Already we have seen the New Orders print of the Philly Fed tumble recently, a slide which was attributed to concerns about protectionism, and one which can quickly spread to both capital markets and the economy.

To better understand the propagation of uncertainty shocks through the economy, BofA claculates that a temporary, one-standard deviation uncertainty shock results in a quick, albeit modest, drop in industrial production (Chart 3).

However, a full blown trade war would result in a larger increase in uncertainty which would lead to a more substantial fall in IP. For example, a three-standard deviation shock would lead to IP falling by nearly 1% in the near term. The impact could be even greater if the uncertainty shock is sustained which would likely lead to an abrupt slowdown in business activity. Combined with a tariff shock, we see a high probability that a major trade war would push the economy towards a full blown recession.

Which brings us to BofA’s summary assessment on the growing threat of a trade war, which unlike several weeks ago, the bank now finds far more pressing:

So far, the trade actions taken by the Trump White House and trading partners have been relatively modest and in turn have had a limited impact on the economy and financial markets. The next round of $100-$200bn of tariff between US and China may prove more substantial. Further escalation like auto tariffs would lead us to reassess the US economic outlook. In the meantime, we will be keeping a close eye on financial markets and confidence data as they will likely give an early indication on the potential impact to the economy.

In conclusion, the Bank writes that whereas the good news is that we are still many steps away from a full blown global trade war, “the bad news is that the tail risks are rising and our work and the literature suggest a major global trade confrontation would likely push the US and the rest of the world to the brink of a recession” as shown in the chart below.

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