There is an increasing threat of a trade war between the US, on the one hand, and Europe and China on the other. As early as now, a pattern is evident where there is back-and-forth retaliation among countries when it comes to imposing import tariffs.
Nobody knows whether this will escalate rapidly. It is generally known that there are no winners in a trade war, only losers. However, President Trump believes the situation is different this time round.
Oddly, however, the damage to share prices has remained very limited so far, and in the US in particular. In addition, long-term interest rates have stayed at low levels, while higher import tariffs are driving up inflation.
We believe the explanation for the above should not be sought in a scenario where investors assume that it will ultimately not be as bad as it seems and that the economy will suffer minimal damage. If this were true, long-term interest rates would have to increase.
What we believe to be the case is that the warnings of a number of important economists are heeded. The latter warn the central banks against hiking their rates too soon and too rapidly, advising them to leave monetary policy as loose as possible. Otherwise, the economy would soon plunge into a recession, while the economy is very vulnerable as a result of the towering debts that exist virtually everywhere at this point.
If the impact of the latter is to be absorbed, interest rates and inflation will first have to climb to far higher levels. This would only succeed if growth were to stay fairly high for the time being. However, this could be impeded by the combination of a tighter monetary policy, higher interest rates and a trade war.
The central banks would therefore have to cease monetary tightening and rate hikes with immediate effect, once the trade skirmishes threaten to shift to an all-out trade war.
We believe the latter point ensures that share prices have so far not displayed a particularly negative reaction to the threat of a trade war, and it also explains why long-term interest rates have come under downward pressure to an extent.
Furthermore, US shares offer a relatively better performance compared to most other countries because US corporate profits are currently rising fast as a result of the tax cuts.
This also explains why the dollar is strengthening gradually rather than rapidly. The Fed is the only central bank that intends to raise its rates fairly rapidly. It would therefore be impeded the most in a scenario where monetary policy has to stay loose.
What is unpleasant about this scenario, however, is that Trump would probably feel free to accelerate trade tensions with China and Europe even more in a scenario where share prices do not start falling rapidly.
This is why we take the view that a persistent loose monetary policy would only come down to a stay of execution for share prices. Our quarterly Investment Outlook report – which will be published next Monday – will include detailed information about further consequences for the financial markets. If you would like to request a copy of this report please send an e-mail to Maria Thorvardardottir.