With the prospect of a global trade war giving the financial markets jitters, Charlotte Moore investigates how much of an impact this could have on the LGPS
While a trade war will create difficulties for all pension schemes, it could have a disproportionately negative impact on the Local Government Pension Scheme because of its high allocation to equities. But determining how to mitigate the impact is far from straightforward.
Opinion on the ramifications of Donald Trump’s tariff policy is divided. Some warn trade wars are never a good idea and have a tendency to escalate quickly. This is likely to be compounded by the president’s mercurial personality.
Others argue that President Trump’s tweets are more bark than bite: strong demands are issued, only to be watered down. In light of recent events, this appears less convincing.
On 1 June, the president announced his intention to impose tariffs of 25% on steel and 10% on aluminium imported from Canada, Mexico and the EU. Both Canada and Mexico have responded with tariffs of an equivalent value on US goods. At time of writing, the EU is still discussing its response.
Keith Wade, group chief economist at Schroders, says: “Germany is cautious as it is concerned if the trade war escalates it will impact its car exports.” And an escalation in the trade war appears more likely. Mr Wade says: “The president has invited a number of new staff members to the White House, who are in favour of tariffs and want to pursue this course of action.”
Even though President Trump’s moves against his allies are unprecedented, a Sino-US trade war will have a far greater impact on the global economy – and there a deep rift between the two regions.
Mr Wade says: “Our emerging market economist visited China recently and said the gap between the two countries is more significant than he had thought.” This means the current trade tensions could turn into a stand-off. Mr Wade adds: “The first wave of tariffs is likely to be implemented by the US.”
Again, at the time of writing the US has said it will announce a list of Chinese goods, equivalent to an import value of $50bn, on which it will put tariffs. China will match these tariffs.
Previously, President Trump had said if China retaliates, he will escalate by putting additional tariffs on a further $100bn of goods. Mr Wade says: “If this happens, it marks the escalation in the trade wars.”
It is unlikely there will be any resolution to these problems, with tensions continuing. Along with the president’s frequent changes in policy, the lack of detail also makes it difficult to read the tea leaves.
For example, the US appears to think China has agreed to reduce the trade deficit by about $2bn but China does not agree, says Jim Cielinski, head of fixed income at Janus Henderson Investors. He adds: “It’s likely the trade balance will decline naturally over the next decade but without any further detail, it’s difficult to forecast how this will occur.”
There are not many ways for China to reduce its US trade deficit without impacting on its longer-term strategic goal of moving towards a more service-oriented economy. Mr Cielinski says: “China will only be prepared to give way on low-value goods such as agricultural products.”
Impact of tariffs
Despite the threat of a trade war, the current impact on the economy is muted. The impact of these tariffs on China and the EU is equivalent to about 0.1% of each region’s GDP. Mr Cielinski says: “While a trade war makes everyone a loser, the surplus country has the most to lose.” The impact on the US will be half that of China and Europe.
Financial markets have shrugged off concerns about a possible trade war because of this limited economic effect. Mr Cielinski says: “This is not considered secular risk because they think China and the EU can give Trump some wins, which will have limited impact on their respective economies.”
Mr Wade adds: “We have trimmed our growth forecasts by 0.2% to reflect this outcome.” But Schroders still thinks a trade war is a key risk for the world economy.
If tariffs were to increase, however, this would have a greater impact on the economy. Mr Cielinski says: “This could have a more meaningful effect because it would come at the end of the economic cycle when risk markets have high valuations.”
Higher tariffs would have knock-on effects on other economies. Mr Cielinski says: “If China upends trade negotiations, it would impact the Asian supply chain, affecting Taiwan and South Korea, in particular.” And in Europe, it would start to have an impact on the peripheral countries. “Italy will not be able to withstand much more additional stress,” he adds.
The president has invited a number of new staff members to the White House, who are in favour of tariffs and want to pursue this course of action
Trade wars can be escalated using means other than tariffs: after all, non-tariff barriers are often more effective at preventing goods and services crossing borders. Mr Wade says: “There are plenty of ways China can make life difficult for US companies through regulation.”
For pension schemes such as the LGPS, President Trump’s Twitter trade tirade might seem more like short-term noise than a longer-term trend but the geopolitical forces shaping both trade policy and the economic outlook look set to continue.
Conventional wisdom says trade benefits everyone, even if those countries are running big trade deficits. That view is now being challenged. As George Magnus, research associate at the China Centre at Oxford University, says: “The rules-based multilateral trading system, which is mostly respected by everyone, is being blown up by Trump’s ‘America First’ rhetoric and actions.”
The popularity of this message cannot be easily dismissed: concerns have mounted about the current system.
Tapan Datta, head of asset allocation at Aon Hewitt, says: “The growth in global trade has increased wealth and income inequalities among those which have no stake in the system.”
Developed country policy-makers and businesses are becoming increasingly frustrated.
Worries around China
Mr Magnus says: “China has been moulding industrial policies which are quite different in focus and type from those which were anticipated when it joined the World Trade Organization in 2001.”
The regulatory regime and competition rules which govern its own and foreign companies in China have become highly contentious, and the bane of many firms that flocked to China to exploit cheap labour and booming markets.
In the years leading up to China joining the WTO, the government understood that liberal reform was necessary. It embarked on a huge programme of privatisation and market-based pricing systems. Private companies were promoted for their export industries.
But as China was deemed to be an emerging market economy, it was allowed to keep certain systems such as tariff levels, subsidies, capital controls and restraints on its exchange-rate system.
Mr Magnus says: “Other countries thought there was a tacit understanding that China would move their industrial and regulatory policies to be more in line with those of developed nations.”
These changes have failed to materialise. Mr Magnus says: “China is now the world’s largest exporter and an aspirant global power.” Developed nations feel increasingly strongly this behemoth should no longer operate as it has and the rules need to change.
But these calls for change are being resisted by China, which feels the rules should be changed in its favour. Mr Magnus says: “This has caused a stand-off which is more than a run-of-the-mill trade argument. We are in the foothills of a trade conflict mountain range which needs to be resolved, if possible.”
There is a good chance trade could become much more focused on bilateral rather than multilateral deals, which could lead to a more fragmented system.
Mr Magnus adds: “It’s always difficult to predict the future but it’s highly likely the world trade system will become more fractured, more managed and more prone to elements of protectionism.”
Mr Datta says: “There could be an increase in non-tariff barriers, which could result in a cold trade war.” Non-tariff barriers typically involve a diverse range of measures, which include import quotas and licences; technical barriers; rules for valuation of goods at customs; pre-shipment inspections and rules of origin.
The combination of tariffs and, more importantly, higher non-tariff barriers could undermine cross border investment. Mr Magnus says: “Many companies invest abroad in order to export products, to play a part in a supply chain for a particular good or service or to acquire technology.”
But the erection of non-tariff barriers and tighter investment rules will discourage firms from making these types of direct investment. Mr Magnus says: “It is these investments which underpin the global trade system.” And these foreign direct investments are also a key driver of long-term economic growth.
Threat of a full-blown trade war?
There are only three ways to run a global trading network. Either the current system of co-operation continues. Or at the other extreme, there could be a complete breakdown and full blown trade war could emerge with the installation of significant trade barriers.
Perhaps the most hopeful outcome is somewhere between these two extremes.
Mr Magnus says: “It would be a world of intense competition where trade and investment decisions become more difficult but there is still a level of engagement.”
This would be a more fragmented trade and investment system where it is more difficult to make gains through trade.
Mr Datta agrees: “While it’s likely that business will probably prevent significant trade barriers from being erected, it is likely trade will become less free.”
The LGPS typically has a 60% to 70% allocation to equities, which are very prone to swings in sentiment
Such changes would have an impact on the long-term economic growth prospects: less trade and less direct foreign investment would make it harder to achieve high levels of GDP growth.
Mr Magnus says: “Open trade and investment flows have been a core feature of the global economy for the last 30 or 40 years. If that changes, global economic dynamism will suffer though it could give advantages to more domestically focused companies, which could outperform their international counterparts.”
The uncertainty surrounding these issues makes it hard to be confident about any predictions. It is impossible to predict how quickly trade flows will fragment and how this potential disruption will flow through supply chains and negatively affect company profits.
But one thing is certain: uncertainty tends to increase market volatility, which could have a significant impact on the performance of local authorities’ investment portfolios.
Mr Datta says: “The LGPS typically has a 60% to 70% allocation to equities, which are very prone to swings in sentiment.” If the longer term outlook is less benign, it might be helpful for pension schemes to reduce their exposure to equities.
The problem of predicting the patterns of disruption makes it hard to know how quickly and when equity allocations should be decreased. Mr Datta says: “It’s too early to make significant portfolio adjustments but it is a risk which should be closely monitored.”
Diversifying away from equities is, however, challenging. Mr Datta says: “Other risk assets also have punchy valuations while a surge in interest in illiquid assets has made their pricing less attractive.”
The LGPS will need to keep its fingers crossed that the disruption in global trade patterns happens slowly enough for it methodically to reduce its equity allocation.