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Authers’ Note: Trade Wars: Not Good



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Before trading began on Friday, we were treated to what will probably be one of the more memorable presidential tweets:

After a day of messy trading, the S&P 500 ended up slightly for the day, so the stock market did not hand Donald Trump a fresh rebuke for his decision to levy tariffs on aluminium and steel imports, but the damage to sentiment is already clear. 

For those keeping score, the S&P is now very slightly positive for the year so far, and back within its trading channel of the past two years. At least part of the sharpness of the selling this week came because the rebound after the correction at the beginning of last month had come with indecent haste. Technical analysts would probably predict that we need to test the levels of the 200-day moving average, and the bottom of the trading channel (which remain very close to each other) once more before the incident can be declared closed.

As for those tariffs, opinion is running heavily against the president, at least among those who broadcast their views on markets. The only strongly dissenting voice I have heard on this issue so far belongs to Stephen Jen, the highly respected foreign exchange analyst who now runs Eurizon Capital in London. Here are some extracts from his latest notes on the situation:

We do not share this prevailing opinion, and have these thoughts. 

1) The US is the least protectionist large economy in the world, while China is the most protectionist. In our note on this subject a couple of weeks ago, we pointed out that the US, based on data from the WTO, is by far the least protectionist nation in the world (with the exception of a tariff-free city state like Hong Kong) — far more open than Europe, Japan, and especially China. And it seems a bit hypocritical to us that more protectionist nations are complaining about the actions of the least protectionist nation.

2) Excess capacity in China. China has half of the world’s steel production capacity, much of which is excessive and unnecessary, even Beijing would admit. The 2008-09 RMB4 trillion stimulus in China further boosted China’s industrial capacity, including in steel and other sunset industries. This has led to a situation where Chinese steel production had to be exported to the rest of the world at very low prices. Some in the US, not surprisingly, consider this ’dumping’. Further, both the US and the EU share the verdict that China is still not a ’market-based’ economy, because of the large and persistent explicit and implicit government subsidies, and other forms of support from the public sector, that make Chinese products unfairly competitive. 

3) Why is Europe not held to the same standard as the US? Europe is complaining about the US’s latest policy. Investors should know that Europe has already imposed two dozen anti-dumping measures against Chinese steel exports. What then is the substantive difference between the anti-dumping measures imposed by the EU and what the Trump Administration is doing? Is Europe less protectionist than the US? If Europe were so open, what is all the fuss about Brexit and the inability of the UK to access the European market?

That gives us his defence of the morality and practicality of the president’s actions. In a later passage, he also gives his reasons why he suspects that trade will end up being a non-issue:

Our expectation is that this struggle on trade will ultimately end up in a less protectionist China and the EU, rather than a more protectionist US. It may look and feel messy for a while. But ultimately the global trade arrangements will be more fair than it is now, and at least as free as it is now. 

Already, China has been a good global citizen. In the steel industry, China has been curtailing its exports, which now account for 9.1% of total steel production in 2017, down from 13.8% in 2016. Since 2011, China has cut its exports to the US by 31%. It will also soon announce several reform measures that will address some of the non-tariff issues mentioned above. 

Bottom line. In our opinion, the debate on trade policies is far from a lop-sided discussion between an irrationally myopic Trump Administration on the one hand, and a liberal and learned rest of the world shocked by such foolish policies, on the other hand. There is a great deal of hypocrisy, gaming, and politicking. But in the end, we are optimist on how the world will look: free and more fair trade. Between here and there, however, it may look and feel messy. 

Nobody can disagree that this move has muddied the waters, and that it will probably contribute to volatility for a while. But if there is no direct retaliation, there is a decent chance that the incident will peter out with nobody worse off.

While there is a chance of this, however, most think the chance of such an outcome is rather low. The greatest cause for hope is that the countries that stand to be most negatively affected, because they export the most steel to the US, are the EU and Canada, strong allies who would prefer not to let the incident intensify:

Citi Private Bank go into interesting detail on the risks of retaliation, particularly from China for whom many political issues complicate their likely response. That is what matters most now: who does what next?

Canada and the European Union have already said they would take still-to-be-disclosed countervailing steps in response to the US steel and aluminum tariffs. This is in addition to taking complaints to the World Trade Organization. Yet as we understand it, the reason for the US actions on steel and aluminum stem from China’s high level of industry capacity and influence on global metals markets.
Importantly, the move comes after both houses of the US Congress passed steps that could be interpreted by China as threatening to the "one China policy” on which trade and diplomatic relations between the two countries is based. Earlier this week, the US Senate passed a bill to encourage visits between US and Taiwan “at all levels”, especially “cabinet-level national security officials”. This follows earlier passage in the US House, and awaits President Trump’s signature. Notably, in the past year, the administration has moved to clarify that its view to the “one China policy” had not changed.
US protectionist trade policies have so far elicited little response from China and we see significant scope for cooperation. However, in our view, a perceived challenge to sovereignty could substantially reduce China’s willingness to cooperate on all matters. In the view of the US, the Congressional bill could merely be seen as a signal of friendship and support to the Taiwanese. It is unclear if this is seen the same way by Chinese officials.
Turning to China’s economy, the silver lining is that its macro environment is less vulnerable than 2014-15. China’s FX reserves have risen for a year by $160bn. Its economy is moderating from the 4Q pace, but remains in solid expansion. Past domestic policy tightening and the US dollar’s weakness have created some room for Chinese policy to accommodate potential setbacks in trade. Tariffs on steel could even help to push progress in the reduction of overcapacity and pollution.
There remain many uncertainties as to how either side takes the issues from now. The coming weeks could be crucial to gauge how far the US is going with protectionism and how much reaction comes from China and other trading partners. Still, diplomatic and trade confrontation with the US would be a net negative on China’s growth and on its currency, as well as market sentiment. If left to fester, this could present a key challenge to our generally positive world view. 

That sounds a little unduly positive to me. Ben Inker of GMO published a brilliant essay taking apart the ideas and motivations behind the tariffs. Making clear that "trade wars are bad" and that nobody wins from them, he shows that steel and aluminium production figures for the US suggest that the country has very little to win from its tariffs:

With production close to or above recent averages, there is no evidence that the US has any new sources of production that can be swiftly switched back on in response to fresh demand driven by the tariffs. However, Ben is less concerned than Citi, largely because GMO was far more negative towards the US and its assets in the first place: 

Despite everything I have written above, we have not made, nor are we planning, any material changes to our asset allocation portfolios. The proposed tariffs and the likely limited responses by our trade partners would probably constitute a net negative for U.S. stocks relative to the rest of the world, but we already are positioned for that given valuations. The tariffs do increase expected inflation at the margin, but we have already tried to position ourselves recognizing inflation as a threat. In benchmark-aware strategies, we are generally at (or are close to) our maximum bet against the U.S. equity market. In our benchmark-free strategies, we recently restructured our last material net U.S. equity exposure — our Quality strategy — as a long/short position against the S&P 500. In our multi-asset strategies generally, we have lower than normal weights in risky assets, less than normal duration, and own significant amounts of TIPS, which provide at least some inflation protection. While we by no means welcome these tariffs, we are comfortable with our current positioning given them. Contrary to what Donald Trump appears to think, I believe that the U.S. imposing unilateral tariffs is more negative for U.S. companies than it is for the rest of the world. A full-blown global trade war would be a different matter, and we would expect emerging companies as the suppliers to the developed world to be particularly vulnerable. We have known this to be a risk for our emerging positions, and we do not currently see any reason to change it. We hope, and at this point expect, that cooler heads will prevail and a global trade war will be averted. But let’s be clear — no one would win a trade war, and investors should realize that they would lose along with everyone else.

That about covers it. For the time being, the announced tariffs somewhat complicate the economic outlook, and slightly worsen the likely performance of the US compared to the rest of the world. We cannot go much further than that until we know how others respond.

Pricing power

One intriguing price movement on Friday came from McDonald’s. It has been heavily advertising its discounted meals in a fight for market share, but is finding it tough. On Friday, an analyst for RBC cut sales forecasts for the restaurant chain, and it was greeted with its worst day’s performance since the thick of the crisis in 2008. 

McDonald’s performance over the past decade has been impressive, but the market is now scared that it lacks pricing power. And if hamburgers and fast food are mired in deflation, why exactly are we worried about inflation?

A further illustration is the performance of the consumer branded goods colossus, Procter & Gamble. Their performance over the past decade has been terrible, and again it is plain to see that the market does not have faith in its pricing power:

Scheherazade Daneshkhu had a fascinating Big Read this week on the trouble for fast moving consumer goods (FMCG), which is well worth reading. This is bad news for shareholders in large incumbent FMCG companies like P&G, or also for people with stock in restaurant chains. 

For those worried by inflation, however, it seems rather healthy. These market concerns suggest that they are very worried about pricing power, which is alarming for companies and their profits, but rather positive for consumers. 

Ice hockey

There is an interesting new research paper from financial heavyweights Cliff Asness and Aaron Brown on the subject of ice hockey. (Or just hockey for North Americans). You can read it here.

They look at the odds and the strategy behind taking off a goalie at the end of a game. Hockey teams are allowed six players on the ice at any one time, one of whom can be the goalie and is allowed to handle the puck. He is generally very heavily armoured. When a team is a goal down, it often pulls its goalie with a minute to go, so that it can outnumber its opponents six to five in the open ice. This increases its chances of scoring but also increases the chances of conceding a goal into an empty net. At that point, it is a risk worth taking. And according to Cliff and Aaron, after crunching the probabilities, it is in fact a risk worth taking far earlier, and even when two goals down. 

Why do two hedge fund managers bother with this? They may in part be motivated by the fact that hockey is an extremely exciting sport to watch. But they do come up with a financial lesson as well:

A chief-investment officer (CIO) who runs a tight ship, putting his money with low-fee index funds and moderate fee active managers who beat their benchmarks, is perceived as an excellent manager (more so these days than in earlier times when perhaps the opposite, a CIO investing only in high fee ex post successful stock pickers, was conventional wisdom). Although he is indeed likely to be excellent as those are good things, they are nonetheless sometimes not good enough, in which case a CIO should look into alternative choices and new types of risk. For example, accepting some leverage risk for the benefit of additional portfolio diversification, or taking some liquidity risk in exchange for higher expected return. But if these things don’t work out, the CIO can lose his reputation for competence; and if they do work out, well, everyone knows it was luck because all those things were risky. As John Maynard Keynes pointed out, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” This applies to both coaching sports and portfolio management. We can also apply this lesson to security selection. Cheap stocks (using simple ratios like price-to-book or price-to-sales) tend to outperform expensive stocks. But they also tend to be “worse” companies — companies with less exciting prospects and more problems. Portfolio managers who own the expensive subset of stocks can be perceived as prudent while those who own the cheap ones seem rash. Nope, the data say otherwise.

There is even another angle. Buying is difficult, but selling is far harder. That is where the worst mistakes are made. And there is an analogy between hockey and investing:

Investors have been shown to be reluctant to sell their losers (part of the so-called “disposition effect”) presumably as selling is psychologically “locking in” a loss. Might the extreme reluctance towards pulling the goalie, when say down two with more than ten minutes left, be the result of a similar cause? Pulling the goalie earlier may be the best action in terms of expected points but runs a very high probability of going down three goals, and thereby almost “locking in” the loss.

So it is worth the time of some hedge fund managers to go into depth on hockey strategy. Honest, it is. 

And what cannot be denied is that the closing minutes of a hockey game can be very exciting. This is how a youthful Bobby Orr famously clinched the Stanley Cup in over-time for the Boston Bruins in 1970, and then immediately seemed to take flight. Enjoy the goal and enjoy the weekend:

authersnote@ft.com

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