Tinkering with trade introduces unintended risks for investors

We’ve been both wrong and right about the timing of certain U.S. policy developments in recent months. On the one hand, we expected to see a tax bill signed into legislation sometime in 2018, but that transpired shortly before the close of 2017. On the other hand, we also expected that the U.S. administration would manage to push through new policies this year with respect to two areas in which the president has significant authority—immigration and trade; on those matters, we were correct. Trade is our central topic in this quarter’s outlook.

In March, the U.S. administration announced tariffs on aluminum, steel, and a range of other items, amounting to roughly $60 billion, a figure later multiplied, on goods imported from China. Such distinctly protectionist steps—initiated by the U.S. government—have moved the world perilously close to the precipice of a trade war, and contrary to what certain presidential tweets have suggested, trade wars truly have no victors. Even if recent U.S. measures provoke only a trade spat rather than a full-scale war, the result would likely include weaker U.S. economic growth.

In and of themselves, the initial tariffs announced on aluminum, steel, and a raft of other Chinese goods didn’t necessarily represent a direct and imminent economic danger for the United States or China. However, the U.S. administration’s subsequent announcements have escalated the tariffs to a degree that would render them more macroeconomically significant, if implemented. That being said, it’s unclear whether the tariffs will actually be implemented as announced or if some negotiation will soften them. Either way, what’s most worrisome is how these prospective trade barriers have come about and where continuing down this path could lead the global economy.

After imposing blanket tariffs on aluminum and steel, the U.S. administration granted a number of trading partners temporary exemptions, including Canada, Mexico, the European Union, Australia, Argentina, South Korea, and Brazil. Suddenly, nearly two-thirds of the imports represented by these goods will now be exempt from the tariffs. Looking across the U.S. workforce, there are far more users than producers of aluminum and steel goods. For every job the tariffs might save, there are likely to be more threatened. These tariffs could therefore impinge on the competitiveness of U.S. industries using aluminum and steel. There’s also a chance some of the cost of these tariffs will be passed on to the end user through price hikes.

Citing Section 301 of the U.S. Trade Act of 1974, the U.S. government has put together a package of tariffs, amounting to 25%, on a number of Chinese imports in roughly 1,300 product categories. These tariffs, if implemented, would be much larger in scope and size than the aluminum and steel tariffs, and would therefore correspond to a more commensurate drag on competitiveness and an upward push on prices. The United States imported a total of $463 billion of goods from China in 2016, and the tariffs on the table would hit items representing around 13% of this total—a material figure in absolute terms, albeit much more modest relative to the size of U.S. GDP or outstanding U.S. external debt.

China has retaliated by announcing roughly $50 billion in tariffs on U.S. products, focused mainly on agriculture, aircraft, and automobiles. In response to this retaliation, the U.S. administration has hit back with a further $100 billion in tariffs, although the details are still outstanding. China can’t actually match the most recent round of escalation in kind—it simply doesn’t import enough U.S. goods. While China could announce tariffs on U.S. services, it’s likely that the country would rather respond with measures that aren’t directly tied to trade at all.

If implemented, the tariffs announced on aluminum, steel, and other Chinese products would no doubt drag on growth and cause some acceleration in inflation, but what’s more worrisome is how they’ve come about and where a further escalation of tensions could take us.

The aluminum and steel tariffs were justified using Section 232, a Cold War-era clause in the General Agreement on Tariffs and Trade, which allows countries to invoke national security to impose trade barriers. Countries have avoided invoking this clause for fear that others would do the same, sparking a trade war. The White House broke this decades-long gentleman’s agreement, setting a precedent for other countries to follow suit.

The imposition of the aluminum and steel tariffs also represents a departure from a consistent rules-based, process-driven approach to policymaking in general. This could be one reason Gary Cohn resigned as director of the National Economic Council, a role designed to shepherd economic policy through traditional channels. Instead, the president took a different tack, announcing the tariffs without much detail and without buy-in across his administration. Moreover, the tariffs were announced without details on what the U.S. administration really wants from China in response. Trading partners, including those in Europe and Japan, who would be inclined to build a coalition and align themselves with the U.S. government are therefore confused about how they should respond to the U.S. moves to tax Chinese goods.

Most alarming, the economic analysis incorporated into the decision to launch some of these tariffs appears counterintuitive. First, tariffs create deadweight losses for an economy overall, leaving all involved worse off. Second, if the United States really wants to address its current account deficit with other countries, it should first look in the mirror and sort out its own imbalances. The current account balance is equal to the difference between national savings and domestic investment. The United States runs an account deficit with many countries because its national savings rate is low and its domestic investment is high. This could be corrected by reducing domestic investment, although that seems unlikely given the sustainable demand for U.S. dollar-denominated safe-haven assets.

One alternative approach for the U.S. administration would be to stop worrying about the current account deficit; another approach would be to just accept lower GDP growth. Either way, the solution to the persistent U.S. deficit lies within the United States and has very little to do with imported aluminum or steel or Chinese technology.

"... if the United States really wants to address its current account deficit with other countries, it should first look in the mirror and sort out its own imbalances."

Of course, the tariff announcements may represent an Art of the Deal style negotiating tactic, whereby the U.S. administration puts out its hardest line first and then backs off. While this may work for the aluminum and steel tariffs—indeed, the United States has since agreed to changes to its free-trade agreement with South Korea and the tariffs may have helped U.S. leverage in those negotiations—we believe strategic bluffing represents a risky approach to trade policy with China. Forcing China to negotiate under such circumstances could backfire; Chinese leadership may not be willing to concede much to the United States for fear of looking weak. After all, President Xi has consolidated his power to become China’s strongest leader since Chairman Mao, but President Xi’s counterpart in Washington—a controversial figure even within his own party—can’t make a commensurate claim. Furthermore, the Chinese government is committed to the Made in China 2025 initiative to support technology and help the country become a world leader in artificial intelligence and other cutting-edge technologies. It’s difficult to envision China backing off of this strategy for growth.

Even if recent moves in trade policy by the U.S. administration don’t result in the abatement of major trade deals, such as NAFTA, the imposition of tariffs and subsequent retaliation could have a major impact on global growth. Full-blown trade war or not, any major move toward protectionism risks hindering global supply chains and weighing down investor sentiment.

According to a 2016 OECD study, generalized tariffs of 10% would reduce global trade volumes by roughly 6% and global GDP by over 1% over a number of years. This represents a more extreme scenario than we’d expect, and the implications of the U.S. administration’s trade policy are unlikely to push the world into a global economic recession; however, the perils for the United States are higher than they might seem on the surface since downside risks to growth are rising. Industrial production, durable goods (nontransport), and hours worked all fell in the first month of 2018, and retail sales have fallen for three straight months. Despite the perceived optimism embedded in equity prices, this hardly represents a running macroeconomic start to the year. There are increasing signs that the U.S. consumer is reaching the end of the borrowing cycle, and U.S. corporations—particularly those operating outside the technology and pharmaceutical industries—remain very highly leveraged. Each of these risks presents increasingly greater trouble as monetary policy tightens and interest rates rise.

In short, the next U.S. recession doesn’t appear imminent, but escalating trade tensions could tip the balance from benign to bad quite quickly.

"There are increasing signs that the U.S. consumer is reaching the end of the borrowing cycle ..."

After 16 straight months of gains, the S&P 500 Index produced a garden-variety correction with uncharacteristic speed in early February. In fewer than 10 hair-raising trading days, U.S. stocks lost more than 10%. Dormant throughout last year’s smooth and steady equity market gains, the Cboe Volatility Index—the VIX—changed vectors even more abruptly. The VIX had reached record-low, single-digit readings last year, but on February 6, it spiked to an intraday high of 50.¹

Investors should ask whether or not this rapid change in direction and magnitude of equity price movements represent a material inflection point, a sign of more dramatic changes to come. History may offer some guidance: Volatility rose on Black Monday in 1987, when the market lost almost a quarter of its value in a single trading session. Equity price volatility also preceded the bear markets that cut stock values in half in the wake of the 2000 tech bubble, and then in half once again during the global financial crisis.

In today’s environment of unusual uncertainties, we see plenty of potential inflection points across global capital markets—not just for stocks, but also for bonds, commodities, and currencies. On the one hand, certain asset classes in select regions of the world seem poised to compensate long-term investors for bearing the risk; on the other hand, it’s not difficult to find financial assets priced to offer little more than return-free risk. Regardless, we’re highly confident that the low-volatility regime that accompanied an era of ultra-low interest rates—cheap money, really—has already hit an inflection point. Moreover, whatever the tax man giveth, the saber-rattler of trade can taketh away. This balance of pluses and minuses will be fought out over the course of the coming months and years. In the meantime, expect more volatility ahead across the global capital spectrum. 

Emerging-market corporate earnings growth has outpaced strong stock price movements, so the valuations of these shares remain well below their counterparts’ in more developed markets. Better growth prospects for lower prices amount to higher long-run expected returns than virtually any other asset class on offer. While emerging-market equities outperformed the rest of the world last year, they barely kept pace with the fantastic rate of corporate earnings growth, so the category still remains—in our view—attractively priced. Much of Asia is leveraged to a global economic recovery providing a positive tailwind. We see good longer- and shorter-term values across Asia’s equity markets, and looming on the horizon lies a new economic force just awakening from reforms—India. Over time, we expect India to begin catching up with China, in terms of per capita GDP. In the meantime, South Korean equities still appear undervalued in this age of rare bargains; however, the region’s manufacturers may well be among the first casualties if a trade war materializes in earnest.

Long-term investors in Japanese stocks have started to see the rewards. Japan also benefits from prospective padding to guard against tough trade rhetoric. The country has found itself in the cross hairs of U.S. trade negotiators before, most notably with respect to auto and steel imports in the 1980s, and it has learned how to respond to such pressure. More specifically, Japan has developed broad trade agreements across the world to help insulate it against single-country sources of discontent. Meanwhile, European equities don’t look as attractive as they did this time last year. It appears that the strong European economic recovery is in the process of rolling over. On the margin, the exceptionally strong Purchasing Managers’ Indexes (PMIs) have gone from booming to a mere steady growth.

As if we needed more alarm bells, the U.S. administration is now proposing about $150 billion in tariffs on Chinese imports. Equity investors like free trade, one of the only principles universally favored by virtually all economists. Market participants dislike uncertainty, and the trade proposals, higher interest rates, and company-specific troubles of certain mega-cap tech leaders have pushed the S&P 500 Index off its upward trajectory, an inflection point resolved in a negative way for those who continue to count on a quick buck. That said, risk assets, including U.S. stocks, tend to experience the worst corrections when facing an economic recession, and we don’t see a high risk of recession over the next three years.

There’s a strong case to remain negative on global bonds as major central banks attempt to normalize interest rates and reduce balance sheets. Bondholders have been riding a 35-year bull market in prices (a bear market in yields, as bond prices and bond yields move inversely). We appear to have reached an inflection point in capital market liquidity. Certain central banks are beginning the long process of exiting the easy money strategies that they’ve applied so liberally since the 2008 crisis. The world’s two largest economies are in monetary tightening mode, with the U.S. Federal Reserve (Fed) leading the charge and the People’s Bank of China curbing credit growth.

In addition to a less accommodative monetary regime in America, U.S. policymakers have embarked on staggering fiscal expansion. More deficit spending means the U.S. government and the Fed will both be selling bonds. Fewer buyers and more sellers means rising yields, all else being equal.

There’s also been an uptick in delinquent credit card and mortgage payments, revealing that U.S. credit markets have begun to deteriorate. For the first three months of the year, corporate credit returns were negative—more negative than those of the aggregate bond market. Credit conditions reflecting rising stress in the system have been a historical harbinger of troubling inflation points. We remain on alert.

Certain Japanese government bonds still yield roughly zero. In Europe, too, we continue to see distortions caused by the persistent supply of liquidity, as so-called high-yield bonds in some European markets are, paradoxically, trading at yields lower than those of U.S. Treasury securities, the world’s best-rated credits—buyers of European junk bonds beware.

We tend to view absolute return strategies and certain other alternative assets favorably throughout the market cycle, but their diversifying characteristics can be particularly potent as the cycle matures. One way to think about absolute return strategies is that they’re the worriers of portfolio asset allocation. Instead of thinking about what can go right in financial markets, absolute return managers are obsessed with what could go wrong, and they manage risk accordingly. How do they do it? They’re not constrained by conventional long positions in mainstream markets, many of which appear expensive today. Instead, most absolute return managers can invest in an array of financial instruments—stocks, bonds, currencies, derivatives, short positions—or just about anything that may help generate a positive return with low price volatility and low correlations with traditional stock and bond markets. 

"We tend to view absolute return strategies and certain other alternative assets favorably throughout the market cycle, but their diversifying characteristics can be particularly potent as the cycle matures."

1 finance.yahoo.com, 2/28/18.