Today, the US imposed tariffs on $34 billion of Chinese imports, marking what some see as the official start of Donald Trump’s ‘trade war.’ The trade war story has come to dominate market commentary as the second quarter has progressed, deflecting attention from the issues that had grabbed headlines at the start of the period.
Interestingly, most of the stories that have come to the fore of late have more in common that it may seem.
Italian politics, emerging market fears, and trade wars all represent situations where what has actually happened is relatively benign, but market pricing reflects fear that developments are only the first step to potentially very bleak scenarios.
We have previously posted on Italian politics and emerging markets. In Italy, the rejection of a proposed finance minister should have little or no impact on the economy, but investors are worried because it could be the first step to a battle with the ECB, default, or even exit from the EU.
Similarly, while rising US rates and a stronger Dollar undoubtedly have direct impacts on emerging market economies, it is the prospect of such moves developing into full blown balance of payments crises that creates the real fear.
Today’s attention on trade wars is perhaps the clearest example of this dynamic. The consensus view today is that trade measures by the US, China, and others so far are largely negligible in the context of overall global trade, and in the trade of either the US or China themselves:
Unsurprisingly, forecasting the true impact of tariffs is very difficult, particularly in a world of more interconnected global supply chains, but those who have tried have tended to come up with an impact on US GDP of less than 0.5%, and often much less (see for example here, here, and here.
In all cases, these models fall into the category of quantitative pseudoscience that Tristan discussed recently (note the false precision in attempts to quote tariff impacts to two decimal places!) We should therefore be sceptical of their value, but they do illustrate that it is fear of ‘tit-for-tat’ escalation, rather than announcements so far, that is worrying investors.
A pattern of action followed by retaliation has certainly been followed in the last three months and China has already announced that its own retaliatory tariffs are in effect as of today.
Up to now, market responses to such news have been relatively selective. China and related markets have been the weakest in this phase.
In contrast, the US equity market (in no small part supported by the strong performance of the large technology stocks) and even Australia, which is often seen as closely tied to Chinese growth but has avoided US steel tariffs so far, have been resilient.
However, there might be signs of broader concerns. In conjunction with global macro data which has continued to be softer relative to expectations, the trade war fears do seem to have had an impact on perceptions of global growth prospects. The flattening of the US yield curve has again captured attention, but this time has been different.
In contrast to much of the environment of the last twelve months – in which the curve has flattened because short rates have risen but yields at the long-end have been stable (‘bear flattener’), moves in June were driven by more material yield declines in longer maturity bonds (‘bull flattener’).
One should be wary of reading too much into this, but it is perhaps reflective of greater outright pessimism regarding the global growth outlook. Data will be playing a major role, but the timing of the bull flattener does lend some credibility to the argument that trade war fears are having an impact.
Thinking about these risks: sell discipline and value investing
These types of environment, where apparently minor developments could reflect the first steps on the way to something more significant, illustrate once again why it is flawed to consider risk solely in terms of volatility (Joe Wiggins mentions this in terms of ‘tail risk’ in a post this week on the ‘is volatility risk?’ debate).
They are also a challenge for human psychology. Many investors claim to eschew forecasting and focus only on ‘facts,’ but it can nevertheless be tempting to believe that the facts today have set in motion an irrevocable train of events. As human beings we also fear looking foolish and naïve. No-one wants to be exposed when the worst does happen after ‘all the signs were there’ that it could.
This is where ‘sell-discipline’ becomes extremely important. Sell-discipline is not about price targets or stop losses but about the flexibility to acknowledge when the facts have changed and to avoid becoming wedded to investment positions that you held when the landscape was different.
Today we can see why investors would be fearful: a single issue is dominating commentary, it is easy to picture negative scenarios, and an intensification seems inevitable. If there is no intensification, or more importantly, if other positive developments occur that we may not even be thinking about today, then the market reaction so far is likely to be overstated and represent an opportunity. On the other hand, if the fundamental situation does deteriorate, we must not be dogmatic in our views.
As human beings, hindsight bias tempts us to believe that once something has happened, it is because it was always bound to happen, and that we should have been able to predict it ahead of time. However, we need to make peace with the reality that we cannot know the one path that the future will take. Successful investing often relies on just this humility.