Shifting market narratives suggest the latest squall may not have passed, even though the solid underpinning of the global economy is likely to prevail in the coming months.
We increased our tactical equity exposure during February’s market correction on the view that investors would ultimately focus on the world economy’s positive fundamentals. Last week, with the S&P 500 index flirting again with its 2018 lows, that view is clearly being tested.
There appear to be multiple drivers of this latest bout of investor angst. The correction in tech stocks and widening Libor-OIS spreads have commanded recent attention but we are turning our attention to two related factors: ‘Bad Trump’ and the increased risk of trade wars.
Over the past few weeks, investors’ view of the US president, Donald Trump, has undergone a marked shift.
Fast disappearing from sight is ‘Good Trump’, the cutter of regulation and taxes who helped fuel the 2017 equity rally. We may now have to contend with ‘Bad Trump’ – the protectionist, the militarist and the conspiracy theorist.
Indeed, I fear that Trump might decide at some point to fire Robert Mueller, the US special prosecutor, triggering a constitutional crisis with Nixon-era echoes. Though many people discuss this possible outcome, we do not think markets are pricing in this risk. Hence, we believe it is too soon to declare ‘Peak Bad Trump’.
Escalating tensions over trade have strengthened the Bad Trump narrative. Trump has moved to slap tariffs to the value of US$50-60 billion on imports from China, in response to a report detailing abuses of US intellectual property by the world’s second largest economy.
For its part, China has announced US$3 billion of retaliatory measures, in reaction to an earlier bout of tariffs imposed by the US on steel and aluminium. The proportional nature of this step suggests a potentially much more aggressive response to the latest US move.
The direct economic effect of 25% tariffs on US$60 billion of US imports (and the equivalent, in retaliation by China) would only be about one or two tenths off US GDP and a similar uplift to inflation. But this ignores potential negative effects on financial markets, investment and the risk of a further escalation.
This situation could resolve itself with China offering some concessions and the US reducing the tariffs to levels with a minimal macroeconomic impact. But this is a hope, rather than a view. It is, therefore, too soon to declare ‘peak trade war’.
How do we invest in an environment that is driven by this kind of political news flow? We do not believe it is possible to get ahead of the curve by trying to interpret and trade or geopolitical incidents while they occur, due to their unpredictable nature. We wonder what our edge is in trying to predict the next tweet or the next cabinet resignation. However, it is more important to understand that while the immediate impact on markets is sometimes significant, it is rarely lasting.
The key is to assess what such events might mean for the fundamental drivers of asset returns, such as growth and earnings. There may be an instant expansion in risk premia, accompanied by an evaporation of liquidity, but any long-term effects will be dependent on areas like consumer confidence or world trade. In this light it is important that our economists believe that the impact on growth from the tariffs as announced, remains small.
This leads to the following balance of risk and opportunities: On the one hand, we see structural headwinds like demographics, low productivity, high debt levels and low trend growth and increasing geopolitical risks, at the moment driven by quite erratic and unpredictable news flow. On the other hand, there is a strong cyclical growth picture and markets are already pricing in quite a bit of the shorter term risks.
We realise that it is quite impossible to predict peak Bad Trump or peak trade war, so we have to pencil in further volatility. However, on balance, we are sticking with our tactical long position as we continue to expect economic fundamentals to prevail in the coming months. We think it is too soon to anticipate a recession and become structurally more bearish.