Trade tensions could reduce global GDP

---

• The United States and China trade negotiations differ from the previous NAFTA and KORUS negotiations.
• There is a significant likelihood that U.S.-China trade tensions will remain high.
• Effects on the global economy are uncertain and dependent on the level of tariffs, the goods impacted, and how long they remain in force.

The United States and China trade negotiations differ from the previous NAFTA and KORUS negotiations

Prior to the recent developments in the United States and China trade negotiations, our understanding of the trade conflict was heavily influenced by the U.S. administration’s previous negotiations with South Korea, over KORUS (United States-Korea Free Trade Agreement), and with Mexico and Canada, over NAFTA. In the discussions with South Korea and those with Mexico and Canada, it appeared the U.S. administration’s main focus was on creating headlines and not materially altering the frameworks governing trade and investment flows.

However, in the U.S. and China trade discussions, there are a significant number of constituents that support material changes to the framework governing trade and investment flows. In spite of this, we previously believed that President Trump would choose to sign a deal, despite some of his allies describing it as a “weak” deal, rather than escalate the trade conflict further.

Recent developments in U.S. and China trade negotiations

Progress toward a trade deal between the United States and China came to a halt, as President Trump announced that he will raise tariffs on $200B of Chinese imports. In response, President Xi announced China will impose approximately $60B of tariffs on some U.S. imports effective June 1. The President and his political advisors appear to believe that the President has more to gain politically from being seen as “tough” on China than he has to gain from signing a deal that some people might describe as “weak.”

“The President and his political advisors appear to believe that the President has more to gain politically from being seen as ‘tough’ on China.”

We do not believe that China will agree to U.S. demands in the near term and will not easily compromise its strategic interests, just as the Chinese authorities also cannot be seen to be weak in the face of U.S. demands.

Trade tensions are likely to persist in the near term, but may dissipate as the June G-20 meeting approaches.

We believe the chances of an early resolution to this conflict are slim and that there is a significant likelihood that tensions will remain high over the next few weeks.

Looking past the next few weeks, two scenarios appear likely: First, the political calculus shifts in Beijing, Washington, or both, and a face-saving compromise can be reached. The weakness of asset markets will, of course, have some influence on this political calculation. The second scenario is that no agreement can be reached. Trade restrictions would remain in force and a resolution would not occur until much later, potentially not until after the next Presidential election in the United States.

Given these two scenarios, we believe the first is more likely. Washington’s appetite for sustained trade conflict with China will likely dissipate, allowing a deal to be reached. A deal may be possible as early as the G-20 meeting in Japan in late June.

With that said, the decision-making process within the Trump Administration is difficult to assess, challenging our confidence in our ability to predict the outcome of the trade war.

Effects on the global economy are uncertain and dependent on the level of tariffs, how long they remain in force, and the goods impacted.

• We believe that given the measures enforced in April, global GDP growth could decrease by approximately 0.2%. The measures that have been implemented in May, and those under active consideration in Washington and Beijing, may cut global GDP an additional 0.1%.
• Additionally, the IMF, using some cautious estimates about trade restrictions, has suggested an impact on the U.S. economy of approximately -0.6% of GDP over two years, and an impact on China of approximately -1.5% of GDP over the same period.
• Depending on the length of the tariffs and the number of goods they affect, the impact on global growth could easily exceed 1% of GDP given the probable effect on the large number of countries that have a high beta to the evolution of final global demand growth.

“Depending on the length of the tariffs and the number of goods they affect, the impact on global growth could easily exceed 1% of GDP.”

Given the recent political developments outlined above, in our view these estimates are likely to be understated. Asset markets have proven to be sensitive to developments in the trade war, while weaker equity markets will have an impact on both household spending, business confidence, and investment. Exactly how large these secondary effects will be is dependent on the final resolution of the current trade conflict.

The impact on Putnam fixed income portfolios

We have been managing our fixed income portfolios with reasonably low risk for a little while, due to our view that risky assets are richly valued given the overall outlook.

With that said, we expect U.S. risky assets to outperform global risky assets if trade war tensions remain high given:

• The U.S. economy is relatively closed; therefore, negative effects from global trade tensions are comparatively smaller.
• The Fed has more ability to respond to economic downturns relative to other central banks.

Moving forward, our evaluation of developments in the U.S. and China trade conflict will inform our assessment of the overall economic and policy environment. This assessment will affect both our duration posture and our exposure to risky assets. These discussions are held frequently, and we are ready to adjust portfolio positioning at any time.

Sources: Bloomberg, Putnam.

317205