Pricing in Trade Wars Versus Pricing in Recession Risks

Investors are starting to see a path form for the United States and China to find a way out of their economically and financially-damaging trade war. After months of little more than a few words of optimism from only one side of the table – which was frequently reversed only days later – we are starting to see conviction from high level officials on both the American and Chinese sides. This past week was the most encouraging period for this year-long economic conflict, even offering a few tangible policies to break through some of the skepticism that had calcified these past months. Following an announcement of five MOUs (memorandums of understanding) to form the backbone of a deal, negotiators made a concerted effort to dazzle the markets Friday suggesting that significant progress had been made and that a summit between Presidents Xi and Trump was being arranged, perhaps for the end of March. And, while some of the US team qualified that some structural policies and intellectual property protection were unresolved, reports that an agreement was already made to prevent current manipulation and that China was prepared to buy $1.2 trillion in US goods indicated serious collateral to push the deal through. 

So, now what? Will committed breakthroughs and tangible deadlines prompt successive legs of a sustained rally? We have already seen a significant recovery through the opening two months of the year offset much of the painful slump through the fourth quarter of 2018. This wasn’t a recovery forged ‘in spite of’ the unresolved situation between the two superpowers. There was invariably a healthy measure of speculation that a breakthrough would be found in the foreseeable future. It is unlikely that the full weight of this fundamental threat has been fully shed by opportunistic interests (just look at the Australian Dollar or emerging markets), but we would not likely see a full economic recovery even if the issue were fully reversed. For trade wars, there remains the uncertainty that the US could engage other major economies. In particular, there is reasonable concern that the Trump administration could apply hefty tariffs against imported autos and auto parts. That would put a severe strain on relationships with the EU and Japan (some of the largest developed world economies), and the former has taken pains to spell out its preparations for retaliation should the US move forward with the Commerce Department’s recommendations. How much concern for future possible engagements is already weighing the market, it is impossible to tell; but the sheer economic implications suggests it is not being taken seriously as yet. 

Pricing in the rise and fall of trade wars can be complicated and volatile given the variable scale of the impact and the flippancy of headlines involved, but some of the direct economic impact related to this threat are not so capable of being fully accounted for in prevailing market prices. In other words, we can fully discount a full blown trade war in the short-term with a sharp decline in assets, or completely alleviate the pressure with speculative appetites reverting to complacent norms. In contrast, the implications of these efforts tipping the economy over the edge into recession cannot be adjusted for in spot. There is no ‘sell the rumor’ on true economic contraction that can see a ‘buy the news’ as the pain unfolds. The markets simply continue their tumble as capital is divested from financial, fixed and human assets. This is where market participants should tread more carefully about their calculations for the near future. The trade wars may have seen their peak, but economic data suggests the momentum if dragging us closer to the cliff. 

Central Bankers to Testify to Their Governments and the Markets 

Monetary policy around the world is in a difficult transitional phase. After years of unprecedented easing and venture into unorthodox stimulus programs, it seemed that we had finally found the central banks’ nadir. Though the Federal Reserve was the only major bank to actually take meaningful steps towards ‘normalizing’ its balance sheet and rates, many other outfits had taken small moves or had signaled their paths had leveled. Considering this shift was taking place years after the global economy had righted itself from the Great Recession and markets charged back towards record highs, the sentiment the transition engendered was a mixed one. While in part a sign of confidence that conditions had improved, it had also left the markets with the clear impression that the effectiveness of their policy tools had all but collapsed. If these officials had years for the economy and markets to return to cyclical norms while their own policy settings slowly reset to afford a future crisis-fighting platform, this lack of capacity would fade into the backdrop and perhaps not even resurface in the next economic slump. 

Yet, conditions are already getting rough and there is virtually no buffer rebuilt. Now some authorities are starting to recognize the trouble in the environment and the impotent position for which they find themselves. There are a few strategies being pursued to inspire confidence. The least surprising tonal change is the commitment to turn back to a dovish setting and provide further easing should conditions warrant it. While not unexpected, it raises serious concern as it highlights the lack of capacity they were hoping to paper over. The other unofficial approach to dealing with 2018’s volatility and the unmistakable slide in growth forecasts is willful ignorance. As all paths of the future are a set of probabilities and they have little ability to affect systemic change by their hands, why not just profess optimism and try to inspire consumption, investment and expansion through their own enthusiasm. Neither of these are the kind of options that could genuinely fend off genuine trouble, but it is where the policy authorities currently find themselves. The Fed’s minutes this past week has built on the speculation that new hikes would come this year (priced into the markets) with clear suggestion that the balance sheet wind down would stop – still around $4 trillion. 

This will make Fed Chairman Jerome Powell’s testimony in Congress this week that much more important. The conversation goes where the Senators and Representatives steer it; but expect assessment of his economic forecasts and evaluation of external risks. We may also find our way to some incisive questions as to the lack of means left to the world’s largest central bank. There will similarly be a Parliamentary testimony delivered by key members of the Bank of England (BOE) – as well as an open presser on a separate day. Here, the attention will be more directly fixed on a specific fundamental risk to the local economy: Brexit. There are other speeches scheduled by members of other central banks along with important data that often goes into authorities’ separate mandates. Yet, almost regardless of how the data populates or how the central bank members come off (optimistic, fearful, dovish, etc), the markets will be more critical with the overt troubles on the horizon. 

Another ‘Meaningful Vote’ as Brexit Realities Come Into Play 

As of Wednesday, there will only be 30 days until the scheduled March 29th Brexit date whereby the United Kingdom and European Union are due to spilt ways. Given how much back and forth there has been on this process, it is easy to forget that lawmakers were looking for a deal sometime this past September or October from which they could begin preparations for the actual Brexit date. Now, they are simply scrambling to secure a legally-binding agreement rather than end with the ambiguity of a ‘no-deal’. There is little doubt that some parties are using the pressure of the clock to draw more submission from their counterparts for a better overall deal. Traditional game theory applies, however, with the parties needing to have a degree of cohesion within their own rank and a general acknowledgement of the risks that their side faces. There isn’t strong evidence that these factors are present in this particular match. 

With a few painful defeats for the Prime Minister this past month and the EU making little movement to meet the requirements laid out by Parliament’s amendments to their leader, we are coming upon another important day in the Commons. On February 27th (Wednesday), MPs are set to debate whether they should take over greater control over the divorce proceedings from May. Previous votes looking to do exactly this were rejected, but time is growing very short. Furthermore, there have been a number of Conservative and Labour members who have publicly left their party owing largely to the lack of meaningful progress in the negotiations. Another crimp to the process are reports late this past Friday that senior members of May’s government have called on the Prime Minister’s resignation by the month of May.

 That could be construed as troubling, but it could also signal acquiesce to a deal in exchange for a change in leadership. Over the weekend, May promised a vote on her latest Brexit deal by March 12th, looking to buy a little more time at home and likely to avert a more serious defeat that could make negotiating with European counterparts armed with grand threats all but impossible. How much good will does Theresa May have to buy more time to negotiate when so little time remains? We will find out on Wednesday. In the meantime, concern by investors, businesses and consumers – already showing hints of panic – will increasingly translate into action. Investors will move their capital out of the Pound and Euro, businesses will push forward with their ‘no-deal’ contingency plans and the more alarmed Brits will look to safe guard their accounts from financial jolts. Anticipation and fear can carry very real world and lasting impact.