It has begun.

President Trump recently fired the first shot against the rest of the world by imposing tariffs on imports to the tune of $34 billion. The tariffs cover various goods from China, as well as $3 billion on aluminum and steel imports from Europe. As has been widely publicized, the affected countries retaliated with equal measure.

We believe the trade war is likely to escalate before these countries are able to negotiate an agreement that suits all interested parties.

Before we get into the core of the paper, we'd like to state that it would have been prudent to establish a bi-lateral trade agreement with U.S. allies before engaging in a trade war with our largest offender, which is indisputably the country of China. As we know, China is a country historically known to manipulate its currency and infringe on copyrights, while its practice of subsidizing its companies continues to this day.

With that said, the objective of this paper is to explain how the imposition of tariffs and associated policies may affect capital markets over the medium and the long-run.

Impact on Commodities

Historically, commodities have been the first to feel the impact of any trade disagreement. The U.S. exports over $130 billion in agricultural products annually, with over $20 billion going to China alone. Soybeans, cotton, corn, wheat, dairy, meat, and grains constitute the bulk of these exports.

In the short-run, making changes to the supply chain isn't possible and since most of these exports are perishable, a major price decline will likely ensue. However, in the medium and long-run prices tend to find a new, and typically higher, equilibrium.

As for energy and oil, we believe these commodities should hold up well in the short-term but if the trade war is prolonged, it is possible that this scenario could provoke an economic slowdown which would most likely impact demand and lower prices. Other commodities, such as gold, timber, and forest products should do well regardless as these can be stored, or in the case of timber, left to grow.

Impact on Domestic Equities

As we know, not all equities are the same and companies with low foreign exposure tend to generate relatively better returns in such times. Generally, these are smaller-cap companies with little exposure to factors beyond their own shores.

From a sector perspective, equities in the materials sector tend to perform best. For example, domestic steel companies are the biggest and direct beneficiaries of the steel tariffs levied on the Chinese firms. On the other hand, the consumer discretionary sector tends to struggle as raw material costs increase, this is especially true if the firm has limited capacity to raise prices without impacting demand.

In general, the technology, communication and health-care sectors hold up better in such an environment.

Impact on International Equities

Developed international equities generally have a similar reaction to tariffs as domestic equities because tariffs are levied by both sides using retaliatory tactics. The reaction of emerging economies, conversely, varies both by geography and sector.

China and the U.S. are both big trading partners of various emerging countries. Many goods and raw materials from emerging countries are used in Chinese and U.S. finished products before making their way to the outside world. 

Impact on Fixed Income

The United States is in a unique position due to its control of the world's reserve and trading currency, the U.S. Dollar (USD). United States treasury bonds and bills provide a haven for investors during times of turmoil, which leads to USD appreciation and lower U.S. interest rates. Global bonds, especially those denominated in local currency, tend to under-perform. Emerging market bonds tend to do the worst as there is a flight of capital to safer countries.

Investors should ponder the implications of a trade war escalation and how it may impact their portfolios. Our bottom line is that all this talk of trade wars and tariff implementation has, and will continue, to create market noise and additional volatility. But over the long-term, portfolios should remain relatively unaffected. This is, of course, if the weight of additional tariffs begins to impact prospects for global economic growth and creates consequential demand destruction.

By: Vipin Sahijwani, President & CEO of Lynx Investment Advisory.

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