After the truce: what happens if the trade war spooks financial markets?

Brendan Rynne, Partner, Chief Economist
Brendan Rynne, Partner, Chief Economist

The global stock markets have been suffering pre-Christmas jitters this week over fears of a possible US interest rate rise and a general alarm over the world economy.

But this would be as nothing, compared to a potential over-reaction by already nervous financial markets to an escalation of the US-China trade war.

A new KPMG paper, After the truce: what happens if the trade war spooks financial markets? shows such a scenario could seriously damage both countries economically and reduce world GDP by 3.5%.

Australia, which would inevitably be caught in the crossfire, would be severely damaged by the fallout. Our GDP losses over a decade would run to an estimated AUD$423bn, and household income losses would total AUD$522bn.

The US would plunge into recession, with its GDP cut by more than 5%, while after a decade, China’s GDP growth would be more than 6% below the level it otherwise would have been.

Other major economies would fare slightly better than the US in the shorter term, but their recovery from the financial market meltdown would be slower. Europe’s GDP after two years would be cut by an estimated 3.2%, and overall global GDP more than 3% lower than it otherwise would have been.

Readers may know KPMG Australia has taken a keen interest in the ongoing tariff war this year. In our previous reports*, our modelling has assumed rational behaviour by financial markets, but the new paper models the consequences of a market meltdown – which could be triggered if equity and debt markets lost confidence in the rules-based global trading system as the trade war continued to escalate and spread to other countries.

What could spook the markets? They could take fright about an expected reduction in future economic growth and the inflationary impacts of an ongoing trade war. This might take the form of a spike in risk premiums, sharp sell-offs in equity markets and a major tightening of credit conditions.

As this week has shown, we are already beginning to see signs of this.

The scenario modelled by KPMG Australia involves the imposition of 25% tariffs on imports of all goods between China and the US (which could happen after the current 3 month truce runs out, unless the two countries can reach an agreement) with a substantial number of other countries responding by applying 15% tariffs on their imports of goods.

Added to this, the following assumptions are made relating to financial markets:

  • Global equity markets over-react to the trade war, falling by around 10% more than is consistent with fundamental valuations. This equity market overshoot occurs in the first quarter of the simulation with markets reverting back to equilibrium over the next three quarters.
  • The term premium on long-term government bonds for the major economies increases by 50 basis points for the first year before reverting back to equilibrium over the next year.
  • The spread between corporate and government bonds for the major economies increases by 50 basis points for the first year before reverting back to equilibrium over the next year.
  • The spread between lending rates to households and government bonds for the major economies increases by 50 basis points for the first year before reverting back to equilibrium over the next year.

A financial market meltdown of this type – even if it is short lived – has the potential to have large negative impacts on the real economy and seriously exacerbate the impacts of the ongoing trade war. In this scenario, our modelling shows the US economy would be plunged into a deep recession lasting more than a year.

Australia and China would weather a financial market meltdown better than most in the shorter term, but the total impact on Australia of a full trade war exacerbated by a financial market meltdown would be grave. Our new modelling confirms the lessons from our previous studies – no country wins from trade wars, and it is every nation’s interests not to get drawn in.

We must hope a wider trade agreement can be reached by the main players in 2019. A happy – and prosperous – New Year to you all.

*This new report is the third study KPMG Australia has published on the escalating trade conflict between the US and China. In August 2018, KPMG Australia issued Trade Wars: there are no winners.

The new paper, published today, builds on the scenarios outlined in that report.

In April 2018, KPMG Australia issued The Re-emergence of Protectionism. 

Read the latest report, After the truce: what happens if the trade war spooks financial markets?

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