Capital Economics warns of "fragile" state of global trade relations

Capital Economics analysts caution that the recent U.S.-China trade truce is fragile, citing potential flashpoints and the possible reinstatement of tariffs in July and August. While extensions are possible, markets may face renewed volatility as negotiations continue, with the effective U.S. tariff rate already at its highest level since the 1930s by some estimates. The report highlights that agreements with Canada, Mexico, South Korea, Australia, and India are more likely, while deals with the EU and Japan face significant hurdles and certain sectors remain at risk.

Analysis

Investor caution regarding global trade dynamics remains justified despite recent positive developments, such as the U.S.-China trade truce. Capital Economics highlights the "fragile" nature of this detente, pointing to several upcoming "flashpoints" including the potential reinstatement of paused reciprocal U.S. tariffs on most countries in early July and the resumption of delayed China levies in August. Should these duties revert to their April 2 levels, the effective U.S. tariff rate could increase by seven percentage points. Even without these reinstatements, some estimates place the current effective U.S. tariff rate at its highest since the 1930s, compounded by an existing universal 10% tariff and specific duties on items like steel, aluminum, and auto parts. The Trump administration has indicated it will impose heightened tariffs on trading partners not negotiating in "good faith," with a focus on 18 key relationships. While agreements with Canada, Mexico, South Korea, Australia, and India appear more probable, negotiations with the European Union and Japan face considerable hurdles due to issues like the EU's trade surplus and Japan's call for auto tariff rollbacks. Specific sectors, notably semiconductors (potentially impacting Malaysia and Vietnam) and pharmaceuticals (affecting Ireland and Switzerland), are also at risk. Capital Economics' base case assumes an eventual tariff regime resembling today's—elevated but moderate duties on most partners, with significantly higher tariffs on Chinese goods—but this outlook hinges precariously on the U.S. President continuing to heed more moderate counsel, indicating substantial underlying uncertainty and a moderately negative sentiment with a notable potential for market impact.

Key Decisions for Investors

• Investors should maintain a cautious stance, recognizing the fragility of current trade agreements and the potential for renewed volatility as tariff deadlines approach in July and August.
• Monitor developments closely, particularly regarding U.S. negotiations with key trading partners like China, the EU, and Japan, as outcomes could significantly impact market sentiment and specific industries.
• Evaluate portfolio exposure to sectors vulnerable to tariff escalations, such as semiconductors and pharmaceuticals, as well as companies with significant international supply chains, particularly those involving China.
• Consider strategies to mitigate risks associated with trade policy uncertainty, such as tactical hedging or adjusting allocations towards assets less sensitive to geopolitical trade tensions, especially as negotiations may extend to their deadlines.