Should you be worried about Trump's trade war?

Donald Trump has consistently railed against free trade, ever since he became a public figure in the 1980s. And during the presidential campaign, he heavily criticised trade agreements such as Nafta (the North American Free Trade Agreement), for destroying US manufacturing, and called for tariffs to protect American firms from foreign competition.

For a while, many people believed that he had been persuaded that protectionist measures would be bad for the US economy. He ditched his plan to scrap Nafta in favour of renegotiating it, and adopted a more conciliatory strategy towards China. But now he seems to have reverted to his original views.

It started with his decision to impose steel and aluminium tariffs on the rest of the world, including Europe, earlier this year. He is now threatening further tariffs on Chinese goods. Europe could be hit too, having been singled out for higher tariffs on cars. To examine whether this could get out of control and turn into a full-scale trade war or whether it is just another bit of bluster, we turned to Luca Paolini, chief strategist of Pictet Asset Management.

Could it all just be bluster?

It's possible, says Paolini, that as with North Korea Trump is pursuing an aggressive negotiating strategy with Europe aimed at getting a wider trade deal; we should be cautious about equating scattered attacks on any one sector with broader, across the board, protectionist measures. For a trade dispute to rise to the level of a trade war' we would have to see US tariffs raised significantly. Even now, "there is plenty of room for a compromise or fudge", with the risk of a large-scale economic conflict still "relatively low at 15-20%".

However, because the economic consequences of a trade war are so huge, even a slightly increased risk should give investors cause for concern. Paolini believes that the US "would almost certainly lose a trade war with China" China owns 10% of US Treasuries, "which gives them the nuclear option of dumping them, pushing up interest rates at a stroke while simultaneously trashing the dollar". Even the EU could hit back at the US by devaluing the euro. Inflation on both sides of the Atlantic would rise, with US companies ironically having their margins squeezed by the soaring costs of imported raw materials.

The sectors that would be hardest hit by a trade war

In the event of a trade war, the European automotive sector is likely to bear the brunt of any tariffs, while US agricultural firms would find themselves barred from markets in Asia. Consumer discretionary is another sector that would do badly due to falling consumer demand and higher costs. Technology companies wouldn't be spared, either. Just as they have benefited from the bull market, the leading companies will be hit on the way down. Regulators in Europe are also cracking down on what they see as technology companies' lax attitude toward privacy.

In the event of a global trade war the only sectors that will be partially shielded will be domestic defensive stocks such as utilities, and financials (rising interest rates typically benefit banks).

Of course, even if a trade war doesn't materialise it might be worth adding these sectors to you portfolio since it looks like "we are in the final stages of the economic cycle", with "pockets of overvaluation" spread throughout the market. Another red flag that the economic weather may be about to cool is that central banks around the world are "doing less, pulling back" and even, in the case of the US Federal Reserve, "hiking rates".

It's important to stress that Paolini doesn't think that an immediate stockmarket collapse is on the cards even in the next 12 months. Beyond that, however, he is far more pessimistic. Investors need to be "much more cautious, as the economic fundamentals are worse that they were six months ago".

Given that equity markets tend to do worse during the summer than at other times of the year (known as the "calendar effect"), investors could definitely be in for a tense few months.