But the real danger is that we see an escalation into a full-blown trade war. Given the rise of economic nationalism and increasing numbers of populist leaders with a shaky grasp of economics around the world, the likelihood of entering a trade war that is in no one’s best interest seems higher than should make one comfortable. Such a trade war would be a profound retreat from the globalization trend we have seen over the last 30 years. It can take years for companies to build out their global supply chains. With the stroke of a pen, political leaders can make those supply chains instantly far more expensive. But this does not make the process of building the domestic capability to replace foreign suppliers happen overnight. Such onshoring would necessarily take time, and frankly would not likely be possible in a lot of cases. In the meantime, widespread tariffs would mean large price rises. Those price increases, in all likelihood, would force the hand of the Federal Reserve to raise rates more aggressively than is currently planned, without any corresponding positive such as would come from an unexpectedly strong economy.
The psychological aspects of a trade war are not to be discounted either. One of the most striking features of investors today is their apparent willingness to look far into the future in assessing the value of investments. Whether this is in the form of high valuations for currently unprofitable but fast growing companies, or real estate and infrastructure investments priced with extremely long payback periods, investors today seem serenely convinced that they can predict what the future will look like.
A global trade war could (and probably should) cause investors to shorten their time horizons, which is a negative for long duration risky assets such as equities. If one wanted to imagine a scenario in which valuations fall not merely to long term historical averages but right through onto the other side, a global trade war is a strong candidate.