Trump, Brexit trade threats may keep European markets underperforming
- US cabinet nominees signal more anti-dumping actions against individual firms
- 28 countries & Euro-Parliament make Brexit talks tricky, so risk of UK tariffs on EU goods may rise
- Markets seem too sanguine.
In BILD-Zeitung on 15th January, Donald Trump threatened BMW with a 35% tariff on imports from its new Mexican factory. Two days later, Theresa May announced that if no deal is reached within the two years allowed for negotiating Brexit, then EU imports into the UK would face tariffs.
Initially, investors seemed to play down the implications of these speeches for European companies. The share prices of major German auto producers fell briefly after Trump’s speech, and then bounced back. That’s a fairly normal market reaction to threats that are vague and in the future. However, past experience suggests that as a danger gets closer in time and becomes more concrete, markets may focus on it and sell off sharply.
What happens when more solid information emerges about threats to trade? For trade between the US and Europe, a general tariff war is highly unlikely, but individual companies may be targeted. But Commerce Secretary nominee Wilbur Ross has signalled greater use of anti-dumping rules targeted at companies that appear to be contributing to the US deficit in an unfair way. Many Republicans in Congress are against protectionism, but such actions can’t be blocked by Congress.
As for Brexit, the UK Parliamentary vote required by the court ruling on January 24th is unlikely to stop the process, though it may impose negotiating constraints on the government. But the likelihood is that Theresa May’s threat will stand, meaning that if no deal is reached within the two years allowed once the process has started, then the UK would leave the EU and could levy the tariffs specified in World Trade Organisation (WTO) regulations. The UK has to negotiate those, because it currently has no independent membership of the WTO. If they are the same as currently apply to EU trade with outside countries, they would be 10% on automobiles. Different levels, generally lower, would apply to other goods, as specified in the WTO spreadsheets, which show thousands of separate entries for everything from eels and octopuses to clock parts and women’s shoes with insoles greater than 24cm.
Neither Theresa May nor any other major UK politician has advocated imposing such tariffs as a desirable outcome, but they do stand as a threat point. The risk is that the negotiations fail even though everyone tries hard to find a solution, because all 28 EU members plus the European Parliament have to agree, which is challenging. Moreover, Angela Merkel has explicitly stated that she will look at the overall deal including social issues like immigration, and will not give special treatment to industrial sectors such as cars.
A year ago, buying European stocks in expectation they would outperform the US was a favourite trade among investment professionals, attracted by lower valuations and the prospect of improving growth. That trade collapsed in failure even before the Brexit vote and the US election, and the valuation gap is now more marked than it was then: US stocks in late January were trading on a 12-month forward valuation of around 17.5 against about 14 in Europe (Stoxx 600) and 13 in Germany (DAX). Historically, the US does on average trade on a higher multiple, but even allowing for that, these gaps are wide. That can reflect various factors, including expected slower growth in Europe and existing concerns over the impact of President Trump’s policies and of Brexit.
The risk for investors is that the valuation gap could get even wider as these trade worries become more concrete. Specific triggers could be US anti-dumping cases against one or more major German companies, or signs of profound differences emerging among the EU countries negotiating Brexit. Moreover, European stock markets often underperform US ones when there is a general sell-off, which could happen if concerns about trade deepen. The conclusion is that investors should stay somewhat cautious on stock markets overall, and should hold lower than normal allocations to Europe as compared to the US, until prices have corrected to reflect more of the potential bad news about trade.