“When the final result is expected to be a compromise, it is often prudent to start from an extreme position.”
― John Maynard Keynes
After negotiations between Chinese and U.S. trade representatives failed to produce a deal or another delay, tariffs on a basket of goods imported from China increased today from 10% to 25%. This was not completely unexpected, but the stock market had priced only a modest probability of the increase actually happening. There is an abundance of evidence to support this assertion: a complacent, low volatility stock market reached a new record high (2945 on the S&P 500) less than two weeks ago, followed by a spike in equity volatility and poor price action, obviously driven by the trade deal news flow. When there was a positive news item (or tweet), the market rallied. When negative, we saw a sell off. As “no deal” became increasingly likely, volatility in global stock markets increased as prices fell – a rational response reflecting the market’s declining assessment of a positive outcome.
Getting a comprehensive deal done was never going to be easy – there are too many moving parts related to intellectual property, human rights and issues of sovereignty, in addition to soybean sales. It is still very likely that a “deal” (however defined) gets done that allows both sides to declare victory. It is just not happening on the market’s – or the Trump Administration’s – timetable.
A negotiation rarely proceeds in a straight line, and generally contains elements of flattery, euphoria, miscalculation, and disappointment. Right now, we are in the disappointment stage. Tomorrow it could be euphoria. Or, should negotiations end and we enter a trade war or prolonged period of tariff tit-for-tat, “disappointment” won’t begin to capture the market’s reaction.
In these negotiations, the U.S. Administration’s approach can be characterized as “negotiating from a position of relative strength.” This manifests in a bruising style that clearly does not follow a prescribed path. We will elaborate below.
The relative economic and political harm caused by the increase in tariffs will fall predominantly on the Chinese – import tariffs are more keenly felt by the country that exports the most, in the form of loss of competitiveness of the export goods, and hence lower export sales. It will not be entirely pain-free, but our economy is better positioned to absorb both an increase in tariffs on Chinese imports AND the inevitable retaliation from China. Our recent economic strength, at the same time that China is attempting to stabilize their growth after several quarters of weakness, puts the U.S. in a position of relative strength. The U.S. economy can take the economic pain.
Both President Trump and President Xi are aware that a full-blown trade war would meaningfully damage both economies, and the political standing of both leaders. This does not mean a mistake won’t be made, but it will work to reduce the chances of an escalation – and increases the chances of a relatively swift resolution, however temporary. Consider that an economic slowdown in the U.S. in coming quarters would work to reduce the chances of Trump’s reelection, a risk he is not likely to take. In China, the economy is fragile and Xi needs economic growth to remain at a level that minimizes the chances of social unrest. So, the threat of mutual assured destruction remains a strong deterrent to escalation.
We would not be surprised by either a swift resolution OR a protracted negotiating period in which the current tariff regime remains in place. We would be (somewhat) surprised by a complete breakdown of negotiations and an escalation of tariffs that results in a full-blown trade war. The damage to the global economy and the stock market would be substantial. A trade war is good for neither country, but the negative effects are likely to fall disproportionality on the Chinese. If true, and the Chinese do not properly account for it, then the probability of a policy mistake increases. And with it, the risks to the global economy and markets.
So, what is an investor to do? Focus on the long term, and on underlying economic fundamentals. They remain relatively supportive of risk markets. It is more important to know what the Federal Reserve is going to do than how or when the trade issues with China resolve – unless there is a total breakdown in the negotiations. In that case these factors become inextricably linked as the Fed will be forced to cut rates to counter the darkening outlook for the global economy. The strategy of brinkmanship increases the likelihood of a policy mistake in a world of political risk.
Political risk is really political uncertainty. The difference is meaningful: risk can be measured, and therefore you can plan for the various outcomes – in statistical terms, you can identify the underlying probability distribution from which the outcomes are drawn. Given a fixed distribution of outcomes, investors can price and hedge various strategies using well-known risk management techniques. Unique political risk, such as the outcome of the U.S.-China trade negotiations, cannot be analyzed using a known distribution of outcomes given the apparently irrational behavior of the negotiators. Furthermore, the goal of the current negotiation is not to maximize short-term stock market wealth, but to force a better long-term deal. What appears to be one person’s short-term irrationality is another’s long-term negotiating technique. That appears to be the case now. It makes assessing outcome probabilities nearly impossible. We can talk about it, but we cannot invest in it, or hedge it, cost effectively.
Our “Pointe of View”
The situation can resolve in one of three ways: a “deal or repeal” of tariffs in a timely fashion – markets stabilize or move up. Or, we get ongoing negotiations with the current tariff status quo, no escalation – markets remain in a holding pattern all else equal. Or we get a trade war and markets drop 10-15%. Given the lack of visibility on political events it’s anyone’s guess. But if we can remain comfortable that a full-blown trade war is not as likely as other outcomes, then we’d look at any substantial decline in the market as a buying opportunity given our assessment of the economy and the Fed.
Most likely, the parties continue to negotiate a more comprehensive deal, and some form of a deal is agreed, victory is declared, and this topic is once again put on the back burner. Timing matters – the sooner the better. In the meantime, we expect policy uncertainty to contribute to capital market volatility, creating opportunities but increasing risks. We continue to monitor the situation closely for clues to the direction of markets.
As markets are unpredictable, Beacon Pointe continues to diligently monitor our client portfolios to ensure the level of risk is appropriate and in line with each clients’ needs. Patience and discipline are key ingredients of successful long-term investing, especially in times of market volatility.
We sincerely appreciate the trust you have placed in us and look forward to our continued partnership in helping you achieve your financial goals. Please feel free to call your Beacon Pointe advisor should you need additional information or have any questions.
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