Protectionism rears its ugly head in U.S. markets

By Kevin Plumberg - Analysis

NEW YORK (Reuters) - A small but significant protectionist measure by the United States against China on Friday may become the first shot in an all-out trade war that could knock down stock markets and the U.S. dollar.

Washington imposed tariffs on coated paper from China on Friday in a policy shift that paved the way for other U.S. businesses to seek relief from China's cheap currency.

The U.S. dollar and stock markets fell on the policy announcement, but managed to recover some ground by the end of the day. However, the risk of more protectionist measures and more stock and greenback weakness stared investors in the face.

"The U.S. introducing protectionist measures is outright dollar bearish and risks undermining equity markets," analysts at BNP Paribas said in a note to clients.

Cheap imports from China, because of its inexpensive labor pool and the yuan's managed exchange rate, have helped to keep U.S. inflation contained since the technology stock bubble burst seven years ago. In turn, that has kept market volatility low and pushed up asset prices.

But the sands may now be shifting.

Though the value of coated paper imports only represent a fraction of the $233 billion trade deficit with China, market players were afraid that the largely political symbol could become a tit-for-tat trade scuffle that would increase inflationary pressures.

"The risks of protectionism in general is to increase the cost of goods and services in the U.S.," said Kate Schapiro, portfolio manager with Sentinel Asset Management in San Francisco.

IMPENDING TRADE WAR?

Schapiro, who manages a $180 million portfolio of overseas equities, said if protectionist sentiment increases she would tell clients to expect more U.S. inflation and fewer cross-border merger and acquisition deals.

But she stressed that things have not yet reached trade-war status. "Sometimes they slap tariffs on a few products to make a statement, and it's more political posturing," Schapiro said of the federal government.

U.S. equity indexes fell more than half of a percent before fighting back and finishing modestly mixed on Friday, but the dollar was down 0.2 percent from late Thursday at 117.80 yen JPY=.

Fears of a trade war with the world's fourth largest economy have now been added to lingering sensitivity to risk in investor portfolios. In late February a surge in risk aversion caused the biggest decline in U.S. stock indexes since the September 11, 2001 attacks and pushed the dollar to a three-month low against the yen.

"This is a bad move and will expose the U.S. to some form of retaliation," said Tom Sowanick, chief investment officer at Clearbrook Financial LLC in Princeton, New Jersey. "This will mostly have an impact on the dollar and perhaps Treasury notes and bonds. I would think the yen and yuan would rally at the expense of the dollar," he added.

China's central bank keeps the yuan weak by actively buying dollars in the foreign exchange market and recycling the dollars by buying U.S. Treasury debt.