International trade winds and stock markets
If the coronavirus situation escalates, world trade is in for a major supply shock that will damage company earnings and productivity. The outlook remains unclear.
There were attacks on the international order of promoting free trade before the coronavirus hit. Many emerging countries refused to make rapid progress to lower tariffs and fewer barriers to trade, wishing to protect their domestic industries and above all their farms. Donald Trump arrived with the aim of having fairer free trade, but willing to use more barriers and tariffs if others did not see it his way.
China claims to be a new champion of the international order, yet still runs a very asymmetric approach to free trade, with plenty of tariffs and barriers against foreign companies and possible investors. The European Union (EU) has been slow to negotiate free trade agreements with the US and China and is fierce in defence of its home agriculture. Despite these imperfections, there has been steady progress over the years to more free trade agreements, as with the EU/Japan Agreement and the Trans Pacific Partnership, and much more progress in getting tariffs and other barriers down between the main advanced countries through the WTO.
The virus has mounted a substantial attack on world trade. It puts people off travelling between countries and continents. It disrupts supply chains by knocking out production in China that is important to assembly factories all round the world. It is making more companies ask themselves the question if it is wise to be dependent on components and raw materials from a long way away if there are alternatives available closer to home. The world has become very dependent on Chinese manufacture in many areas. The West has lived through a couple of decades when it has relied more and more on good value manufactures out of China at the expense of its own industrial production. Suddenly the source of that product has wobbled, revealing to more people just how dominant China has become.
In international trade law, rules of origin are an important part of free trade agreements and trading arrangements. Where there are still tariffs to duck, the company and country claiming the exemption needs to show sufficient value added in the territory concerned. Assembling a lot of parts from outside the free trade area does not qualify. This too pushes more companies to think about more local sourcing. In the UK motor industry, for example, there is a drive to increase the UK content in a UK assembled car for a variety of good reasons including trade rules.
The theory of international trade argues that more trade is a good thing because each country and company can specialise in what they are good at, allowing the rest of the world to buy the best-value product by product from wherever that may manifest. Those who defend this view are apprehensive at the various attacks on free trade, fearing it will mean less productive and more-expensive manufacturing to meet national or trade-rule-based requirements.
It may not be as damaging as they fear. There is a danger from excessive specialisation when that produces concentration. This, in turn, can lead to cartel or monopoly pricing once enough of the global competition is driven out of the market. It takes time for a manufacturer to reorient supply lines from a particular supplier, as they need reassurance about quality, delivery and standards. It seems likely there will now be more moves to diversify away from Chinese manufacturing dominance. This is exactly what Mr Trump wants as he seeks to onshore business to the US. In the meantime, there is a scramble to find alternative supplies where Chinese shipments are interrupted.
We have modified our scenarios for the world economy and markets this year based on the negative impacts the virus and the government policy responses to it are having on output, company revenues and profits.
Our base case still assumes modest growth for the year as a whole but includes a much weaker first quarter and a possible recovery during the second quarter. It has to embrace the fact that many companies will have to report lower earnings and some will experience cashflow difficulties all the time reduced working persists.
Our worst-case now includes a prolonged period of spread of the virus through many countries accompanied by more governments around the world closing down parts of economic activity to contain the epidemic. As more consumers and employees stay at home so they produce less and only spend on food, utilities and in-home entertainments. This kind of supply shock, if it emerged, will be damaging to output and company profitability, and highlight the gap between stock market valuations and the reality of company results.
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John Redwood is Chief Global Strategist at Charles Stanley & Co. Limited, which is authorised and regulated by the Financial Conduct Authority.