Trade Wars Between the US and China – Perhaps the US and the World
The world seemed to be on a very different path a week ago. Through the close on Friday, May 3rd, the rhetoric serving as forward guidance for the US-China trade war was clearly being directed to suggest the end to the economic conflict was at hand. That took a dramatic turn two days later when US President Trump contradicted the leaks of an impending compromise and deal by stating clearly that the United States would raise the tariff rate on $200 billion in Chinese imports that were being levied 10 percent to an even more punitive 25 percent. True to his word, the President ratcheted up the trade war between the world’s two largest individual economies. While this may not have the same level of shock impact as the first venture into the current trade wars, it is notionally the largest escalation and a peak in this period of ‘growth at the expense of others’ policy. With the upgrade in the tariff rate, the White House issued a further direct warning making it clear that the US is willing to push forward and tolerate its own economic and financial blowback to redirect the course of a trade partner that has long defied the conventions of free markets by pursuing emerging market tactics. According to the Trump administration, China has ‘three to four weeks’ to compromise on the United States’ key demands or the trade burden will expand to another $325 billion in Chinese imports (though 2017’s total imports was only $505 billion). Given last week’s unexpected escalation, there is increasingly less skepticism that Trump will avoid further dramatic moves that hold economic consequence for the US as well.
Given the US has pushed forward with an exceptional escalation in the trade wars as of early Friday morning, the market’s reaction through the session that followed comes as quite the surprise. After an initial tumble across the board through morning hours, the week’s final session closed to gains for the S&P 500, the VEU rest-of-world equity ETF, the EEM emerging market ETF, junk bonds and a broad swath of carry trade. We have seen the markets write off other ambiguous issues over the past weeks and months, but the implications behind this situation are unmistakable: there will be negative economic and capital flow repercussions from this situation. Suggestions that the impact will be minimal or that this about face was priced in are nonsensical. Optimism sourced in the fact that the two sides are still talking or that a tough stance by the US will rebalance a global bias that is detrimental to most does not fit with the market’s short-term focus. It would be disingenuous not to mark this market disconnect to some degree of complacency. At what point does the market start to register the pain in the way that we would reasonable expect? Chinese markets (Shanghai Composite, Yuan) will start to process the pressure when government intervention is overridden by the markets. The emerging market and non-US developed market economies are already trading at a substantial discount to the US assets which receive a disproportionate amount of attention. When – not if – the Dow and S&P 500 cave, we are at even greater risk of catalyzing an accelerated and universal ‘de-leveraging’. In the meantime, it will be important to watch the spread of financial troubles beyond the US-China quarrel. The USMCA is still facing an insurmountable wall so long as the metals tariffs persist, there are two direct threats from the US to levy taxes against the EU that have yet to be activated, and the Trump administration has to make a decision on broad auto tariffs as the initial 90-day review process of the Commerce Department’s Section 232 assessment ends on Saturday, May 18th.
The Expanding and Abstract Threat to Markets from Political Risks
When the markets are looking for threats, there is usually an emphasis placed on those risks that are well-defined and carry an explicit date/time. The ‘convenience’ of counting down to a trouble with certain boundaries can help with preparation for its occurence. And, in such situations, the known unknown can also significantly reduce the sense of fear and in turn dramatically temper their impact. In contrast, those storms beyond the horizon that could inflict unknown damage offer poor preparation and conversely amplify the fallout that accompanies surprises. When we consider the dominant fundamentals winds trading influence over the global markets, there ware fairly well-defined criteria to recession fears (global growth), clear timelines for trade wars and key policy decisions that carry greater weight over the influence of monetary policy as a temporary prop and artificial amplifier of speculative excess. The concern that has constantly lurked on the border of our apprehension is the simmering threats from various points of political risks. Political discourse in general has deteriorated over the past few years with economic and defense-based relationships like the TPP, NATO and Iran Nuclear accords all facing existential pressure. Yet, the pressure isn’t simply reserved for ‘external’ trade partners. Nationalism has taken root across the world with an inevitable result of dissonance and resistance to progress where the benefits cannot be guaranteed to be evenly distributed. This is not the first time in history that such a tide has risen, and it will not be the last. When will it have run its course and give way to alliance and progress – as messy as that inevitably will be? That remains to be seen.
In the meantime, we will continue to see the strife that arises from all players pursuing self-interests. The most overt example of this ongoing conflict is between the UK and European Union. The past weeks’ headlines offered little to be enthusiastic over when it comes to compromise for a favorable resolution to both sides. There is nevertheless a time limit in place – whether that be the late October extension deadline or participation in the EU Parliamentary elections from May 23rd to the 26th. Speaking of the forthcoming elections in Europe, there is an unmistakable presence of typically anti-EU nationalist participation and a host of top roles that are up for grabs (head of the European Parliament, European Commission, European Council and European Central Bank). While there are some disruptive voices in the campaigning, no one is as antagonistic as the Italian leadership which is committed to pushing forward with pursuing fiscal support for the economy despite its deficit forecasts ballooning to levels north of the Union’s allowances. In the Middle East, the United States is pushing hard to isolate Iran which is driving energy prices higher and threatening stability in the region – prompting the US to send war ships to the area to prevent rumored threats – while the developed nations fight over the relationship. Asia has multiple points of tension but China’s efforts to promote a sense of cooperation through its Belt and Road initiative are increasingly falling on skeptical views for those monitoring the progress of the US-China trade war. The internal conflict is worst in the United Sates itself. Hopes of massive fiscal stimulus in the form of a $2 trillion infrastructure spending program (necessary to pick up the reins from flagging monetary policy) are potentially held hostage by the growing warnings of constitutional crisis and pressure to pursue impeachment for the President’s perceived transgressions. Any one of these issues could take a severe turn for the worst with enormous consequences for financial stability. For more tracked out Political risks, keep tabs on the known elections around the world – beyond the EU and after Africa’s results have come in, we also have India and Australian campaigning underway.
Volatility Measures are an Imperfect Tool We Too Often Find False Confidence
Considerable weight is afforded to volatility measures as a definitive measure of sentiment. However, there are many caveats to these typical benchmarks that undermine both their presumed timeliness as well as their ability to even verify sentiment. This past week, there was a notable swell in volatility readings across asset class and region – though unusually not in the aftermath of a confirmed escalation of the US-China trade war as mentioned above. FX derived volatility measures hit the highest in six weeks as did measures for yields and oil, while the S&P 500-based VIX volatility index hit an intraday high last seen back in the opening days of January and the emerging market measure exploded to its highest levels since February 2018 when the market first made its transition from an environment of total complacency. There is little doubt that the fundamental gears were turning through the past week, but the concerns starting the engine turning were clearly not deep enough to undermine the markets such that a true market retreat would set obvious, deep roots. It is worth a refresher on the source of these activity measures. The popular indexes are almost universally ‘implied’ figures which are backed out of related options – the VIX is for example measured from S&P 500 options. Given all of the aspects of the traditional pricing model are known with the contract, that means only the ‘implied volatility’ as a measure of uncertainty and thereby the cost of protection are unknown. Also the underlying index may be traded in both directions, but the vast majority of capital behind the benchmark asset are dedicated to a buy-and-hold mentality. That makes options predominantly hedges, and therein lies the negative correlation between the performance of the index and the direction of the volatility measure.
Tracing these indicators back to its fundamental originations, we can better understand their short-comings and perhaps derive some underappreciated signals to use towards our evaluation of the markets and our trading decisions. One of the most overlooked issues is that indicators like the VIX are not indicative of activity itself but rather strong bearish movements in the underlying. That may not seem a problem, but experienced traders will recognize that there is often an erratic nature to markets with violent moves higher or chop back and forth before that intensity is channeled towards a frenetic deleveraging. Another critical shortcoming for such indicators is the fact that they are hedges for which traders frequently disregard at the most inopportune times. Back in the second half of 2017, the US equity markets were defying concern over the upheaval in politics, the growing concerns over global growth forecasts and a march towards a trade war with an incredibly stolid march higher. The run of days without a one percent or greater decline from the S&P 500 hit a stretch not seen in decades. A push to record highs through a period of improbable quiet was destined to ‘revert to norms’ with a slide that would almost certainly offer violence to balance to roaring quiet. It is at such times that there is the most to lose and therefore hedges would be most important to hold. Instead, the VIX printed a record number of days below 10. Of course, we saw how that period ended, with a February collapse across all risk-leaning assets. As misleading as these indicators can become, we can use the lack of counterbalance the indicator should offer as a sign of how disconnected and exposed the participants of the system have become. When ‘realized’ (or actual) activity starts to rise and anticipation remains stoic, there could be systemic risk building that results in not only violent correction but follow through to the unwind.
There is also something to be said about the picture of volatility across the financial system. Most will base their assessment of the market-at-large on a single measure like the VIX, but that is as flawed as using the S&P 500 as litmus for the entire capital market. There can be bursts of activity for certain asset classes with some leading depending on catalysts that can turn systemic (like monetary policy failure driving the FX and Treasury yield volatility measures to life), but there are few better confirmations than ‘fear’ spreading throughout the most liquid asset classes. This is much the way I feel about the direction and tempo of the different key assets like US and global equities, emerging markets, junk bonds, government yields, carry trade and more.