Friday, April 6, 2018

Will Trade Wars Crash Markets?

Ben White, Politico's chief economic correspondent and a CNBC contributor reports, Trump's tariff gamble with China could be catastrophic for the economy, the GOP — and his own presidency:
Donald Trump has decided to gamble his presidency on the idea that he can threaten big tariffs on China and force the world's second-largest economy to back down.

If he fails — and the odds are that he will — the fallout from a tariff battle with China could derail an otherwise strong U.S. economy, threaten Republican majorities in the midterm elections and turn the second half of Trump's first term into a dismal slog to avoid impeachment votes.

So far, the exact scenario that free traders inside the White House and on Capitol Hill feared is playing out. China scoffed at Trump's initial $50 billion in threatened tariffs and announced their own, aimed directly at Trump's red-state base with levies on agricultural and manufactured products.

Trump and his top trade negotiator, Robert Lighthizer, responded by chastising China for not immediately capitulating and announced plans on Thursday night for another $100 billion in tariffs. China, in classic trade war fashion, announced it would "counterattack with great strength" and fight the United States "to the end."

New National Economic Council Director Larry Kudlow, whose main job is to convince Wall Street and the rest of America that no trade war will actually happen, stepped up again Friday in a series of interviews to promise that this is all classic Trump, an aggressive negotiating ploy to get China to clean up its theft of intellectual property and forced technology transfers, among other abuses.

"This is not a trade war. There is no war here," Kudlow said. But he also said there was no timetable for negotiations and that tariffs could actually wind up going into effect. The fact is that Kudlow has no idea how any of this will play out, and neither do Trump or Lighthizer.

The president is approaching this like he does everything else, by talking tough and expecting his opponent to give in. Only it's not at all clear what a "win" in this trade fight would look like or what exactly the White House expects China to do to avoid the American tariffs going into effect.

Trump himself acknowledged in a radio interview aired on Friday that there could be "a little pain" in the trade dispute but that the ultimate outcome would be good for America's economy.

That little bit of pain could turn into a midterm election bloodbath for Trump's Republicans if things go wrong. China may export more products to the United States than the U.S. sends to China. But the Chinese have other ways of exacting pain, including making life difficult for U.S. companies operating in China, limiting Chinese tourism to the U.S., as well as curtailing the number of Chinese students who attend and pay full tuition at American colleges and universities. China could also reduce holdings in U.S. debt.

'This is nuts'

In the midterms, China could continue to target agricultural products in states where Republicans hope to pick up Senate seats and avoid a Democratic wave, including Indiana, North Dakota and Missouri. Nebraska GOP Sen. Ben Sasse was among the most critical of Trump's trade moves on Thursday.

"Hopefully the president is just blowing off steam again but, if he's even half-serious, this is nuts," he said. "China is guilty of many things, but the president has no actual plan to win right now. He's threatening to light American agriculture on fire. Let's absolutely take on Chinese bad behavior, but with a plan that punishes them instead of us. This is the dumbest possible way to do this."

Republicans in Washington are tearing their hair out over Trump's approach. He could be highlighting the strong economy, low unemployment rate and boost from the GOP tax cut bill.

Instead, he's injected massive volatility into the stock market, ratcheting up uncertainty for companies that export to and do business in China and threatening to worsen inflation through higher consumer prices.

"Wage and price pressures are mounting," Moody's Mark Zandi told me on Thursday. "Higher tariffs would only intensify these pressures and cost American jobs. Trump's tariff gambit better end up in avoiding higher tariffs or they will only add to the overheating risks that are high and rising."

All of this might be worthwhile if there were a clear outcome in sight that would benefit the United States. But there isn't. There is a chance that it will all end with some cosmetic announcement by the Chinese that they will reduce some trade barriers. But it's not likely to be anything monumental. And a small reduction in the U.S. trade deficit won't mean anything in real economic terms.

The alternative is that the talking war will turn into a real trade war that could slow U.S. growth, tank the stock market, cause Republicans to lose one or both houses of Congress in November.

And it could present the president with Democratic majorities eager to take whatever comes out of the Russia investigation and turn it into impeachment hearings if not actual impeachment votes.
I reckon there are a lot of nervous Republicans in Washington right now while Democrats are sitting back, mostly staying quiet and letting Trump tweet his heart away.

Trump's obsession with China and Amazon's Jeff Bezos, the world's wealthiest man, are making a lot of investors nervous but he's showing his nationalistic colors and being true to his campaign promises.

Love him or hate him, at least you can see Trump coming from a mile away. He never hid that he wanted to level the playing field with China and he hates the liberal press and Bezos's Washington Post which he feels is a constant thorn in his side.

I had a chat with a friend of mine earlier who trades currencies and he noted that Trump's approval rating is climbing, which is all that matters to him as he sees it as a validation that his policies are what Americans who voted for him want.

My friend noted some other interesting points which he shared with me:
  • For 30 years, US policy toward China was to build a solid economic relationship so US corporations can produce goods at a lower cost and sell them to Americans and others all over the world. Politically, this moved China away from a purely communist country like North Korea, which is what the US wanted, to a mixed market economy which is still communist but has a growing middle class which can buy US and European goods. This policy also weakened labor unions and allowed US corporate profits to soar to record levels, kept inflation and wage growth low in America and elsewhere, and the current account deficit with China was tolerated as long as Wall Street benefited from a capital account surplus to recycle China's savings and speculate on risk assets all over the world. 
  • Now comes Trump who is tapping into the disenchantment of American workers in the Rust Belt, he tells them the level playing field isn't there and that's why manufacturing jobs have left the US but he's going to rectify the situation by standing up to China. The truth is China does get away with murder when it comes to trade but the problem is it's still a communist country. Moreover, it's paying for students to come study in the US so it can steal intellectual property and become a leader in many high-value industries, competing with the US and Europe head-on.
  • In effect, Trump is promoting his economic nationalistic agenda, so it's odd people are surprised. He's not listening to Larry Kudlow, he's listening to Peter Navarro, appealing to his disenchanted base who feel that Republicans and Democrats have let them down over the years to solely pander to corporate interests (ie. campaign contributors).
  • Sure, US corporations don't like trade wars but Trump has given them a huge tax break and has told large companies the US government will do business with them. The money US corporations are saving in taxes can go into investing, increasing wages, paying off debt or buying back shares but they will all opt for share buybacks to increase their senior level compensation which is based on earnings per share. 
  • But China isn't stupid, it's striking back with its own tariffs on American products coming from Rust Belt states, ie. Trump's base. It knows it can hit Trump in areas where midterm elections are taking place in November. It might also choose not to finance US debt but I doubt this will occur and besides, the Fed can just buy US bonds through QE if it needs to.
  • I do not see a US recession before 2020. Trump still has the billion-dollar infrastructure program in his arsenal. The only wild card is the stock market which can get clobbered but even there, he will force the Fed and Treasury to buy stocks, it's already going on through the Bank of Israel and the Swiss National Bank via swaps and outright purchases, and don't be surprised if he privatizes Social Security to force it to invest in US stocks if things get really bad.
My friend got me thinking that maybe there is a method to Trump's madness. He obviously has a clear nationalistic economic agenda to fulfill and he's going to try to score a victory with China, even if it's a pyrrhic one.

I told my friend I've seen Amy Chua, Yale Law School professor, discuss how the US political discussion has segregated the electorate into political tribes on CNBC and with CNN's Fareed Zakaria.

Professor Chua made the point that California and New York want more immigration because it allows them to hire top talent from all over the world, but people in the Rust Belt see more competition from immigrants accepting low wage jobs and they feel disenfranchized.

Anyway, this is the background to my Friday market comment. While everyone is honed in on a full-blown trade war with China, which Paul Krugman calls The Art of the Flail, I believe even before all these escalating trade tensions, the US and global economy were decelerating and that's why stocks are selling off.

A trade war with China just throws gas on the fire but let's be clear, the slump in stocks was already underway.

In fact, Jeff Cox of CNBC reports, The market analyst who called the correction sees a lost decade ahead, but one group will win:
Stifel strategist Barry Bannister called this year's correction pretty much to the day, and he's got even more bad news.

Losers will be passive investors who will see returns fall away as the major indexes don't gain any ground, while winners will be active managers who pick stocks for a living. Managers had a solid year in 2017, while 57 percent beat their benchmarks in the first quarter of 2018, the highest level since the bull market began, according to Bank of America Merrill Lynch.

On Jan. 26, the head of institutional equity strategy at Stifel said in a research note said the S&P 500 was due for a correction, and he was right. The index topped that very day and has fallen an aggregate 8 percent since then as of Wednesday's close. But twice, it has been in correction territory, defined as a 10 percent decline.

On the bright side, Bannister said that for now he is sticking with his call that the index closes the year at 2,800, which implies 6 percent upside. But from there, things get ugly.

For one thing, 2019 is likely to bring a bear market, as he has stated previously. And then, for the decade after that, the market likely will trade sideways, the victim of overvaluation and a retreat from the Fed-fueled bull run that began back in 2009.

The overvaluation comes from looking at rolling price-to-earnings levels over the past 10 years (the "Shiller CAPE"), a comparison of market values to asset values (Tobin's Q), and the high levels of household stock ownership.

"Those three methods imply an abysmal outlook for the S&P 500 return from 2018-2027E and a bear market that probably starts within the next year," Bannister said in a report this week for clients. He noted that nonrecession "bear markets" have typically fallen 18 percent over the past 50 years, though a bear technically is defined as a 20 percent decline.

He also hit at the role that central banks will play for returns.

The Fed and its counterparts goosed the market with trillions in money printing, most of which was used to buy government bonds and inject liquidity into the market. However, policies are beginning to diverge, with the Fed ending its quantitative easing program and embarking on half a dozen interest rate hikes and more planned ahead.

"Central banks front-loaded equity prices," Bannister said. "The 'payback' is now a long, flat decade ahead."

Stifel has been telling its clients to move to more defensive market names as market stasis sets in.
If you read last week's comment on whether a quant style crash has finally arrived, you'll see that I agree with Bannister, it's time to get defensive in your portfolios:
Those of you who hate trading, just forget about these crazy markets, put 50% of your money in the S&P (SPY) or S&P Low Vol (SPLV) and 50% into US long bonds (TLT). In fact, I would even recommend 60% or 70% US long bonds here.

In terms of where to invest, I think US long bonds (TLT) are the ultimate diversifier and the US dollar (UUP) will appreciate over the coming two years, and I'm positioned more defensively in equities focusing on stable sectors like healthcare (XLV) and consumer staples (XLP) and interest-rate sensitive sectors like utilities (XLU), telecoms (IYZ) and REITs (IYR).

Given this defensive stance, I'm underweight cyclicals like energy (XLE), financials (XLF), metals and mining (XME) and industrials (XLI).

Right now, I'm also short tech (XLK) and semiconductors (SMH) and would steer clear of value traps like oil service stocks (OIH) which remain cheap despite the rise in oil prices, and will remain cheap as the global economy slows.
Where I disagree with Stifel's Barry Bannister and Stephanie Pomboy who thinks the Fed will trigger the next crash, is on how agrressive the Fed will be in raising rates while the inflation disconnect continues to baffle policymakers and escalating trade tensions with China threaten US jobs.

The Fed isn't stupid. It knows American consumers are tapped out and that raising rates too aggressively will sink the economy into a depression.

Moreover, as I stated in my comment on the Fed's balance of risks back in late February:
All this talk about the Fed shrinking its balance sheet and its impact on the economy is much ado about nothing.

In fact, if my prediction that the US economy will slow significantly in the second half of the year comes true, I wouldn't be surprised if the Fed pauses its balance sheet reduction or signals a pause.
If the stock market crashes, all bets are off, the Fed will lower rates and enter into QE infinity. That's when you will see gold (GLD) and cryptocurrencies take off.

Will stocks crash? I doubt it, think they will ramp them up going into earnings season and then it will be a lackluster summer (sell in May and go away) but Art Cashin worries that market volatility is reminiscent of the 1987 crash.

We shall see. I see a shift out of high beta into low beta, a slowing US and global economy which supports US long bonds (TLT)  and while the S&P 500 (SPY) is rolling over, it's got support on its 50-week moving average and they will likely ramp it up next week as we head into earnings (click on image):


But with geopolitical tensions on the rise, who knows how the market will react next week.

Below, stocks tumble on fears of trade wars and rate hikes. Discussing the winners and losers at the closing bell with Karen Firestone, Aureus Asset Management; Art Cashin, UBS director of floor operations; and CNBC Contributor Evan Newmark.

Second, Stifel strategist Barry Bannister called this year's correction pretty much to the day, and he's got even more bad news.

Third, Eric Wiegan, US Bank Private Wealth Management; Barry James, James Investment Research; and Danielle DiMartino Booth, Money Strong, discuss the economic and market impacts of growing trade war fears.

Lastly, Amy Chua, Yale Law School professor, discusses how the US political discussion has segregated the electorate into political tribes. Listen to her views, very interesting discussion.

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