The real damage to the U.S. economy will come through trade retaliation since it will hurt business confidence and the financial markets.

In July, the United States and China imposed punitive tariffs on each other’s imports. The European Union, Mexico, and Canada have similarly retaliated against President Trump’s steel and aluminum tariffs. The trade war, should it escalate, is a clear risk to our outlook. Tariffs imposed by the United States on a stand-alone basis won’t materially impact inflation, and while disruptive to specific supply chains, aren’t expected to shift the GDP growth trajectory too much. The greater damage to the economy will come through retaliation, with an impact on business confidence and the financial markets. The critical question is: What is the Trump administration trying to achieve?

Tit for tat

Developments in the last few weeks are making us nervous. First, tit-for-tat retaliation has begun. Trading partners have been careful to match, and not to escalate, but they are retaliating. This is already raising worries among the business community. Second, the scope of concerns being raised by the administration is widening. Trump ordered a national security investigation of the auto industry, which would give him the power to impose the auto tariffs that he mentioned in his tweets. This would be a significant escalation and would certainly be damaging to the U.S. economy. The pipeline is primed for more tariffs. When tariffs against China went into effect on July 6, the Chinese swiftly retaliated.

Developments in the last few weeks are making us nervous. Tit-for-tat retaliation has begun.

Third, evidence of disarray among the administration is increasingly worrying. The administration is clearly divided on trade, and the latest evidence of this comes in the bill that Trump has ordered to be drafted. The bill would give the president the authority to withdraw from the WTO and impose tariffs at will. The Fair and Reciprocal Tariff bill is an indication the bureaucracy is pushing back since Congress will have to review the bill.

Upping the ante

The president has the authority to act on trade, and he’s using it. The only way the trade dispute with China would end quickly would be if the Chinese caved to Trump’s demands. We are quite confident they will not. First, they don’t know whether Trump is serious or not. If they believe the mainstream view — that Trump is all talk and no trousers — they don’t have an incentive to offer much. Second, China has a lot at stake, including long-term goals for their economy. They will not give those up without a struggle and may not give them up at all.

So, the United States has to up the ante. Even if you believe this is only a game — a piece of theater — the threats have to escalate. Since the U.S. policymaking apparatus is barely functional, there is a clear risk that threats become badly implemented policies. China has demonstrated it has plenty of ammunition to deploy, both on U.S. imports and more broadly. The sharp decline in the yuan in late June was followed by a statement from the People’s Bank of China (PBoC) that the currency was not being used as a trade weapon. The statement reminded everyone that the currency was available as a trade weapon, if necessary.

So, the United States has to up the ante; even if you believe this is only a game — a piece of theater — the threats have to escalate.

Since the PBoC is not an independent entity with control over foreign exchange policy, President Xi Jinping can tell the central bank to do whatever he wants. Therefore, we should not interpret statements from the PBoC the way we would comments from the Fed, the European Central Bank, or the Bank of Japan. China can retaliate against U.S. multinationals operating in the country, threatening profit streams and giving equity markets something to worry about.

Downside risks appear

While the central outlook for the global economy remains reasonably benign, downside risks are beginning to appear. If the U.S. economy stays strong, risk of the Fed tightening too much looms large. If the trade conflict escalates, there is risk the economy will weaken. This is because business confidence and investment will be affected, and financial markets have shown their sensitivity to the possibility of trade conflict escalation.

Our central scenario calls for growth to continue, global divergence to partially reverse, central banks to remain cautious, and no eruption in the trade war. Under this scenario, we would expect rates to drift a little higher as cyclical factors push bond yields up, while global factors act to restrain this pressure. It would be an environment in which the dollar would stop appreciating — or perhaps depreciate — and risk assets, particularly emerging markets, would recover.

If these risks materialize, the second half of the year would be more like the first. Government bond yields would not move very much, and risky assets would come under renewed pressure. U.S. risky assets would probably continue to outperform risky assets overseas as the United States does have less overall exposure to trade.

Next: Eurozone growing, ECB delaying

Next: Eurozone growing, ECB delaying

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While the outlook for global growth is favorable — albeit less synchronized — the view could change if the Federal Reserve overtightens and trade spats escalate.