Introduction: The Galton Board
In early March, the Trump administration announced tariﬀs on steel and aluminum imports, reawakening fears of a global trade wear and prompting retaliation threats from the EU and China. The US added to these fears by recently introducing further tariffs on Chinese imports stemming from the US investigation into intellectual property abuses.
Much of the media coverage of President Trump's protectionist policies has made them seem like a game of Russian roulette, with no upside, and a meaningful risk of major downside. But we believe that the Galton Board (see shaded box) is a more apt analogy at this time: the protectionist ball has just dropped, and the outcome will only be determined after dozens and dozens of uncertainties have been resolved.
What is a Galton Board?
A Galton Board is made up rows and rows of obstacles, onto which a ball is dropped from a single point at the top. When a ball hits each obstacle it has a 50:50 chance of falling left or right, and after bouncing its way to the bottom, it lands in one of a number of pots. The New York Hall of Science, which houses one of the world's largest Galton Boards, is just a few minutes' drive from President Trump's boyhood home in Queens.
The key uncertainties
We think the market reaction to US trade policy will go through three key phases, and in each phase, we have been thinking about what might make the ball ping right, or left, on our Galton board.
Phase 1: Will US protectionism measures widen?
The current tariﬀs are unlikely to have a large macro impact as steel and aluminum make up just 3% of US imports. However, ambitious US deﬁcit reduction targets and investigations into China's use of US intellectual property could contribute to the risk of an expanded scope of tariﬀs.
Phase 2: How does China reciprocate?
We see a 20-30% chance of the trade risk scenario playing out of a China retaliation and further US escalation. However, US tariﬀs could also provide upside in the form of cooperation in non-trade related areas such as national security, or by incentivizing other companies to reduce their tariﬀs with the US.
Phase 3: How will central banks react?
We would expect central banks to lessen their tightening bias if it appears growth is under threat from protectionism. But with unemployment at a multi-year low and shrinking output gaps, turning on the easing taps may not be so easy.
So what does this mean?
While we are keenly focused on not underestimating the damage of a possible trade war, we believe it is simply too early to brace for an extreme bad outcome to US trade policy changes, and positive outcomes are not impossible. Instead we advise investors to remain focused on the fundamentals:
We therefore advise investors to:
Maintain a pro-risk stance as earnings and growth fundamentals still remain strong (We maintain a preference for global equities, emerging market equities, and Eurozone equities)
Consider positions to help manage against downside risk and look for opportunities that can perform well in both our base case and in case of a market downturn (Consider hedging strategies and overweight 10-year Treasuries vs. cash).