Episodeblog Quicktake: Trade Wars reignite

Domestic Chinese markets were the hardest hit, with some impact on neighbouring countries.

The source of the moves, were once again tweets out of the US:

Today the US trade representative appeared to confirm the suggestion that tariffs would increase on Friday.

However, despite the language of market commentary, market moves have actually been relatively muted.

Those Chinese markets which have fallen a lot had just gone up a lot (perhaps reflecting previous headlines on both sides that negotiations were going well, but also signs of domestic stimulus and a recovery from weakness at the end of 2018).

Even with the declines on Monday, the Shenzhen and Shanghai indices were up 23% and 16% respectively for the year to date, and have simply unwound some sharp gains in March and April. They also saw a modest recovery overnight.

Similarly, while there has been talk of the Chinese currency tumbling, the move does not look significant from a longer term perspective.

In this respect it is reminiscent of market commentary on Sterling in the UK, which said to ‘plunge,’ ‘tumble,’ and ‘surge’ with every twist and turn in the Brexit narrative but which in reality has been largely stable against the Euro for two years).

There has been general resilience in Australia, New Zealand, Indonesia, and Malaysia, all areas which one might expect to be sensitive to the health of the Chinese economy. Moves in Japan and Korea since they have reopened, as well as European markets, appear normal.

Why has the response (so far) been so limited and should that worry us?

However, just as we shouldn’t always believe that markets are telling us something important when they move a lot, we shouldn’t believe that everything is fine when they don’t.

Tariffs and other protectionist measures do have real world effects. If we look at what has happened to delivered profits around the world over the last twelve months, it does seem that China-related markets have been hit hardest. Even Australia, which could be seen as an exception because it has delivered earnings growth over the period, has lagged other commodity exporters.

This has also been reflected in equity market returns since the start of 2018. Aside from the correlated weakness in February and the final quarter, the period is characterised by underperformance from Asia-Pacific in the aftermath of trade-war intensification.

There are a whole host of other factors that can lie behind this, and we should be wary of an over-emphasis on a single issue. But given that there does seem to have been at least some impact, and the fact that trade wars have dominated the narrative for much of the last year, it does beg the question why the reaction to the latest news seems far calmer than it was last summer.

There are a couple of possible reasons:

The Art of the Deal

Many have treated Trump’s tweets with scepticism, viewing them simply as an attempt to increase pressure on the Chinese to reach a deal (and make more concessions on technology transfer) ahead of a planned visit from Chinese Vice-Premier Liu this week. It has also been suggested that it could be legally difficult for Trump to add tariffs to the additional $325 billion worth of additional imports.

This seems to reflect the consensus belief, and may be a reasonable argument, but it is also possible that it is the very fact that markets haven’t responded which has prompted commentators to look for counterarguments, rather than the arguments themselves which explain market moves.

The Shock of the New

We must also consider the role of path dependency in driving how investors respond. In early 2018, global equity markets had just performed very strongly, and the trade threats came somewhat out of left-field. Markets often respond more aggressively when truly new information arises; investors haven’t had a chance to grapple with fundamental impacts and are more prone to shock.

We have now had over a year to consider likely impacts of trade war measures, and though the new information could present a shift in the extent of these risks, they are not the unknown that they once were.

The Price is Right

Closely related to the point above is the idea that some element of trade war risk is already ‘in the price’ of many global assets, and potentially more significantly, that valuations on equity markets in areas like Europe and parts of Asia already had very negative outlooks on future profits.

This may seem counterintuitive given the performance of stock markets so far this year, but we would contend that much of this recovery is a combination of a straightforward unwinding of the episodic panic that dominated in December, and the abatement of upward rate pressures out of the US.

Even with recent gains the mood is very different to that at the start of 2018. It certainly does not seem that market participants are optimistic for global growth prospects.

Conclusion

There can often be a disconnect by the language used in market commentary and the reality of market moves.

This can be particularly true with a President who still has the capacity to prompt emotional reactions, and after a period in which commentators (like us) have had less to talk about in an environment of relatively low volatility.

Amidst the noise and hyperbole that these dynamics can create, it is important to keep an eye on the facts. In this regard, the questions we should be asking are ‘why has the response been so limited?’ and ‘why is this different from last time round?’

There are a number of answers to these questions ranging from the fundamental (‘Trump is bluffing’) to assessments of the state of markets (‘expectations are already depressed’). If the former reflects the consensus, which seems to be the case, there is still scope for equity markets to be vulnerable to near term volatility given the strength of the rally we have just had. If the latter is a valid observation, then there could well be both a margin of safety in place against further bad news, and the potential for further gains should we get better news on growth.