Why the G7 and global trade talks really do matter
Whatever advisers and clients think of President Trump, his theatrical exit from the G7 meeting in Quebec and subsequent barrage of tweets on trade policy, no-one can ignore him. And this is because the issue of trade and tariffs could have profound consequences, which in turn will have implications for asset allocation and how advisers and clients need to construct portfolios.
In this column’s view, this is the case for three reasons.
- First, history suggests that no-one really wins a trade war. The introduction of the Smooth-Hawley Act in the USA in 1930 is a good example of this. America’s move toward protectionism prompted retaliatory measures from Europe and elsewhere. Global trade suffered as a result and a difficult economic (and financial market) environment was made substantially worse than it may have been otherwise.
- Second, tariffs and protectionism are inherently inflationary as the result is higher prices for consumers. Looking at this through the narrow prism of portfolios, this must be considered at a time when many advisers and clients still fear a downturn, even deflation, or are at least seeking dependable income, and have sizeable allocations to bond funds and equity income funds that are packed with so-called ‘bond proxies’ as a result. If inflation really does take hold, they are the sort of asset classes that could do relatively badly, if history proves to be anything like a reliable guide.
- Finally – and this is where the economy theory comes in – President Trump’s attempts to put ‘America first,’ run a trade surplus and reverse 47 years of economic history could have some very serious side effects, at least if the so-called ‘Triffin Dilemma’ has any say in it. This is because the Trump plan would drain the world of the very dollar liquidity upon which it is reliant. It is already possible to see the effects of even a minor decrease in dollar liquidity (due to rising interest rates and a gentle withdrawal of Quantitative Easing in the USA), given the carnage in emerging market currencies and financial markets. And that is happening after only a mild increase in the dollar’s value and slowdown in supply growth.
Mild increase in the dollar has already hit emerging markets hard
Source: Thomson Reuters Datastream, Bank of England
The current world monetary system was set up in 1971, when then US President Richard M. Nixon and Treasury Secretary John Connally took America off the gold standard, effectively killing the Bretton Woods system set up toward the end of the Second World War. That replaced the pound with the dollar as the globe’s reserve currency, pegging other currencies to the dollar and in turn to gold, for which they could exchange greenbacks.
The idea was that America, the world’s economic superpower, could not easily run a cheap dollar policy and export its way to total dominance or be fiscally imprudent at home. A soaring gold price (or tumbling dollar) would be the sign that the US was printing – and devaluing – dollars.
Just look at how the US trade and Government deficits have mushroomed since Nixon took the hatchet to Bretton Woods.
Twin US deficits have ballooned since the death of Bretton Woods
Source: FRED – St. Louis Federal Reserve database
Amazingly, Professor Robert Triffin foresaw all of this, arguing in a book he wrote in 1960 that the dollar’s global reserve currency status would come at a cost – either to America or the world.
He argued that to provide the world with enough dollars, America would always have to run a trade deficit and import more than it exported, paying out more in dollars than it received, and run an ever-growing budget deficit for good measure.
America must therefore be – and remain – a debtor nation. This is all well and good while confidence in the dollar remains, lenders are happy to lend or hold US Treasuries and the US is happy to run a trade deficit.
But it becomes a problem if lenders lose faith (as they did briefly in 2008) or America’s trade policy is changed.
This is where President Trump comes in.
If he is serious about turning America’s trade deficit into a surplus then we will find out if Professor Triffin was on the money or not, as global dollar supply returns to America, boosting the value of the buck and draining liquidity from the world economy and (probably more immediately) its financial markets.
If he backs off, America will continue to run huge deficits which will need to be funded – probably with more (and not less) QE, the direct opposite of the current market consensus, with all of its potential implications for the potential value of ‘real’ assets (precious metals, commodities, property and shares in cash-generative companies) rather than ‘paper’ ones (cash, paper promises to pay coupons on bonds).
Demise of Bretton Woods has also already had huge implications for US inflation (and thus financial assets)
Source: FRED – St. Louis Federal Reserve database