This is the trade war we didn't need to have. US president Donald Trump's bellicose promise to slap tariffs on steel and aluminium imports will rock our market today and send panicked investors rushing to the exits.
It's not only China that is threatening retaliation. Even traditional allies to the US such as Canada and the European Union are warning against the protectionist move. Australia will have little choice but to respond if its manufacturers like BlueScope Steel Limited (ASX: BSL) are not exempt.
The world has taken a big step closer to a full-blown global trade war. As I warned a few weeks ago, such an event was the biggest and most likely threat to our bull market. If one breaks out, it will certainly change my positive outlook for equities.
But a trade war is not a certainty despite the chest beating from Trump. He's famous for changing his mind unexpectedly and he knows the stakes are high as protectionism will hurt US and global economic growth.
We also do not yet know what retaliatory responses the US will receive, so trying to predict outcomes is nothing more than crystal ball gazing at this point.
Nonetheless, it pays to be prepared as a trade war will force a change in investment strategy in at least three ways.
1) Spectre of Stagflation
Be prepared to pay more to get less. The rise of trade protectionism could contribute significantly to inflation. The US is facing higher prices and other exporting countries to the US could get a temporary drop in inflation due to the potential surplus of steel and aluminium.
But this won't last and inflation will become a contagion at a time when economic growth slows significantly.
This means we could potentially face an era of "stagflation" where price rises but there is no or low growth to help consumers absorb the impact. This is a terrible outcome for stocks so keep your fingers tightly crossed.
2) Impotent Central Bankers
Investment markets have been under the direct control of central banks for nearly a decade since the GFC. Investors have been hanging off every word from the US Federal Reserve and friends as they have supported the reflation trade.
Get ready for a change in paradigm! A trade war will remove power from central bankers as monetary policy will not be able to influence inflation rates as directly as they once did.
What's more, central banks have limited capacity to cut rates to stimulate growth as global interest rates are too close to zero.
They could return to the good ol' quantitative easing (QE) playbook but they certainly have a lot less sway on investment markets than they did before.
3) Change in asset allocation
Under this bearish outcome, defensive stocks (particularly those with market power) will be hot favourites.
I am thinking of the likes of toll road operator Transurban Group (ASX: TCL), whose latest results show they are much more a price-maker than a price-taker, and logistics company Qube Holdings Ltd (ASX: QUB) as its strategically located Moorebank intermodal terminal cannot be replicated.
There used to be a lot more of these price-makers on our market, such as Woolworths Group Ltd (ASX: WOW), but globalisation and foreign competition has changed all that.
Gold will also likely do well in this hostile environment as the precious metal is still regarded as a safe store of value even in this age of cryptocurrencies.
This means stocks like Newcrest Mining Limited (ASX: NCM) might be spared the worst of the sell-off, although the same can't be said for other industrial and bulk commodity miners like Rio Tinto Limited (ASX: RIO) and BHP Billiton Limited (ASX: BHP).
Another asset class that could do well is floating-rate hybrids. That's good news for our Big Four banks that include Commonwealth Bank of Australia (ASX: CBA), Westpac Banking Corporation (ASX: WBC), National Australia Bank Ltd. (ASX: NAB) and Australia and New Zealand Banking Group (ASX: ANZ).
The Big Four are large issuers of hybrids, which pay an interest rate that is usually at a set premium to the interest rate benchmark and with a maturity date that gives investors an option to redeem cash or convert their hybrids to shares.
Floating rate hybrids can provide inflation protection while limiting investors' equity risks in a falling market.
But let's not get too gloomy. Trade war or not, it won't stop some sectors from outperforming over the long-term.
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