While currencies have traditionally been the weapon of choice of countries seeking to quickly reflate their economies, recently governments have been more likely to use tariffs and taxes to maintain competitiveness when faced with substantial trade deficits. During our latest investment policy meeting, this became a key discussion point as the team dissected the implications should international trade tensions increase.
“It’s possible that increased protectionism will be met with retaliation from trading partners, and that’s where the real danger lies for the global economy,” said Andrew Keirle, portfolio manager and member of the global fixed income investment team. “The risks have clearly increased,” he added, referring to the recent U.S. tariffs on solar cell and washing machine imports and the potential tariffs on imported steel and aluminium.
When U.S. President George W. Bush imposed steel tariffs in 2002, the U.S. dollar rapidly depreciated, bonds rallied, and equities fell off a cliff. But the U.S. was exiting recession at the time—a very different environment from today, when robust growth and low unemployment underpin the U.S. economy.
Assessing the potential impact should tensions increase, the investment team noted that currency markets in particular look susceptible to volatility. So far, the reaction of most emerging market and developed market currencies has been very country-specific. The Japanese yen and other safe-haven currencies have shown signs of strength and should continue to do so given the uncertainty and risks surrounding rising trade tensions.
The euro, meanwhile, could be stuck between a rock and hard place if tensions increase. While stronger fundamentals suggest it has scope to appreciate, Germany’s trade surplus with the U.S. potentially makes it vulnerable, especially if the Trump administration widens its tariffs and targets countries with which it has large deficits.
Turning attention to the currencies that could struggle if tensions escalate, the investment team agreed that the Asia region looks vulnerable. “Some Asian economies, such as South Korea, tend to be very sensitive to global trade. This leaves their currencies potentially exposed if the current environment deteriorates,” said Mr. Keirle.
Figure 1: U.S. Trade Balance on Goods and Services With Major Trading Partners
As of March 7, 2018, in USD Billions
Sources: U.S. Census Bureau, U.S. Bureau of Economic Analysis, and T. Rowe Price.
Other higher-yielding Asian currencies, such as the Indonesian rupiah, have the potential to do well. Despite robust fundamentals, the rupiah has fallen to its weakest level in two years recently, which the investment team believes provides an attractive entry point, especially given the country’s scheduled inclusion in the Bloomberg Barclays global aggregate indices in June. The Indian rupee, meanwhile, is a currency that the team has liked for a long time given its attractive carry profile and stable performance behavior in a risk-off environment. But following the U.S. Treasury’s revelation in October that it is closely monitoring India’s foreign exchange practices, the rupee’s potential performance now could be limited to its expected carry.
For now, it is difficult to predict with confidence how this situation might play out. However, a good way to hedge against the possible escalation is to use currency options. In this regard, out of the money call options on the Japanese yen have a lot of appeal, the investment team noted.
Finally, the team said they expect central banks to wait and see what impact tariffs have before responding, potentially delaying necessary monetary actions. “Tariffs risk driving up inflation through increased input costs and companies passing this on through raising prices. If central banks dismiss this as just a short-term phenomenon, they could fall behind the curve,” said Mr. Keirle, noting that this is likely to result in steepening pressures on bond curves in most developed fixed income markets.
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