The days of sleepy summer headlines seem like a thing of the past lately. Everyone's talking tariffs, retaliation tariffs, and trade war. What sort of impact is the threat of a trade war due to these tariffs having on markets? Not to be too cute... but that all depends on the market. There's more than one market in the world of alternative investments. Some markets like stocks and currencies are treating the tariffs as rather binary events to be immediately bought or sold en masse, other markets like soybeans and metals seem to be letting it create a new market environment with different long-term price levels. Both types of reaction matter for investment models, quants, and traders.
Binary Tariff Moves = The bad sort of market volatility
In our Managed Futures / Global Macro 2018 Outlook, we touched on tariffs as one of the ways President Trump's... shall we say, volatility, could impact markets:
And perhaps more so now that we've all been sort of lulled to sleep by the drama in Washington not having any effect on markets. But that's not to say Trump threatening to pull out of something like NAFTA or placing tariffs on solar panels (predominately coming out of China) couldn't cause a market reaction.
Bottom line, the more ultimatums and deadlines we see out of Mr. Trump, the more binary market movement could become - with prices moving quickly to meet the new reality instead of building into a new reality over time.
Our worry was that bluster coming out of the White House could spell trouble for systematic models, and it seems that this year's numerous rounds of tariff threats have been doing just that from time to time. Take equities' reaction to the Trump Administration adding a third round of tariffs on China (at around $200 billion) a few days ago.
Before we put the cart before the horse, this is an hourly chart, only showing the market movement over a 24-hour period, where only one day of gains were erased. This on top of the market rebounding 90 basis points two days following. In the grand scheme of things, this move isn't all that significant, but it does highlight the type of binary market moves that make it difficult for systematic trading models to react. These binary moves tend to stem from ultimatums, deadlines, out-of-the-blue directives, and so on which can spike markets quickly - creating the volatility we all (mostly) want, but with that spike not necessarily being the beginning of a secular move higher/lower, of directional volatility.
This is the pinnacle of frustration for systematic programs which are designed to capture outlier moves. But with binary events like the Swiss Franc, Brexit, and even the VIX Feb spike, the outlier move happens all at once in a sort of uncapturable way (for most). Most systematic models are designed to measure averages and ranges and model risk and reward based on previous patterns and data to identify potential outlier moves being generated over time. They aren't looking for the outlier move to happen all at once. The type of outlier moves they look for are more like combinations of normal moves pushing prices to new highs or lows.
Imagine flipping a coin. Systematic models are setup to capitalize on an outlier event, such as the coin being flipped heads 20 times in a row... risking, say, $0.25 to earn $5.00 in profit (a quarter for every correct flip). The binary events are like changing the game, saying we're going to risk $20 on the next coin flip, and then not play anymore.
As we said in our 2018 outlook, the more ultimatums and deadlines we see out of Mr. Trump, the more binary markets could become - with prices moving quickly to meet the new reality instead of building into a new reality over time. So far, President Trump has threatened or placed tariffs on China, Mexico, Canada, and the EU. But we're not as worried in this space that it will cause a string of market losses or significantly higher/lower prices in different assets - we're worried it will do so in a few hours instead of a few weeks.
Extended Tariff Price reactions = The good sort of market volatility
Here's what a more normal reaction to a trade war and tariffs looks like. Trump's spat with China has caused China to raise prices on US soybeans imported to their country by 25%, which is pushing the futures price of US soybeans so low, it's created a new price environment over the past several weeks. Buyers and sellers are agreeing, in essence, that the price should be significantly lower.
Now consider that soybeans are the second-largest financially important crop in the U.S., with $41 billion worth of soybeans grown in 2017, with corn coming in at $48 billion. Now consider, China is the world's biggest importer and America's largest customer in a trade worth $14 billion last year. With these tariffs, China is turning to Brazil (the second-largest soybean producer behind the U.S.) and removing their 3% soybean tariff on five over Asian countries, to eventually look to other areas instead of the U.S. But it's not just soybeans, it's also pork, milk products, and grains.
In interviews, Midwest farmers reveal the impact tariffs have already had, and the ones they fear are around the bend. In Indiana, pork producers say they've already been slammed by falling prices, starting when the trade war was just a rumor. In Wisconsin, cheesemakers say their overseas buyers are starting to look for new suppliers in order to avoid the tariffs. In Michigan, apple producers fear the fallout if states that do more exporting are forced to dump their product domestically.
If the tick to tack tariffs continue, this could be death by a million paper cut situation model. It's the risking $20 on one bet and not playing again situation. But the long-term effect could have lasting implications for U.S. soybeans farmers choose a different crop, or worse, can't survive to make another crop the following year. This coming on a half a decade decline in soybean prices from drought conditions:
The thing is, Trump's not wrong about prices. Soybeans reached a record of $17.89 a bushel in 2012 and were down by more than 40 percent by the presidential election in November 2016. But that all-time high price came in the midst of a terrible drought in the U.S. Midwest that severely hurt crops. So, when prices came tumbling down, it was a typical market reaction to the end of a supply shock. Also driving the declines: farmers have been collecting bumper harvests in the years since the drought.
Either way, The American Soybean Association isn't happy and has launched a campaign #FacesofTariffs to humanize how bad these tariffs are going to be for farmers in the Midwest. We could realistically be in a world where models and discretionary ag traders will have to start getting intel on how many farmers are still around to grow the crop. For now, soybean prices are tumbling and it doesn't seem to have found a bottom.
Are Tariffs a Black Swan?
A quick side note on this whole trade war/tariff threat to the market(s). It's surprising to see it move markets significantly of late when it has been out in the open and talked about for much of the past few months. The Black Swans made famous during the financial crisis were the unknown risks (even though many people, including these guys, were well aware of the problems). This is not an unknown risk. Indeed, it is actually a chief risk among global fund managers of late:
Which leads us to wonder, along with this Twitter user, whether the real Black Swan isn't a trade war, but the lack of significant effects from a trade war:
Disclaimer: The performance data displayed herein is compiled from various sources, including BarclayHedge, RCM's own estimates of performance based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.
Benchmark index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices such as survivorship, self-reporting, and instant history.
Managed futures accounts can subject to substantial charges for management and advisory fees. The numbers within this website include all such fees, but it may be necessary for those accounts that are subject to these charges to make substantial trading profits in the future to avoid depletion or exhaustion of their assets.
Investors interested in investing with a managed futures program (excepting those programs which are offered exclusively to qualified eligible persons as that term is defined by CFTC regulation 4.7) will be required to receive and sign off on a disclosure document in compliance with certain CFT rules The disclosure documents contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA, as well as the composite performance of accounts under the CTA's management over at least the most recent five years. Investor interested in investing in any of the programs on this website are urged to carefully read these disclosure documents, including, but not limited to the performance information, before investing in any such programs.
Those investors who are qualified eligible persons as that term is defined by CFTC regulation 4.7 and interested in investing in a program exempt from having to provide a disclosure document and considered by the regulations to be sophisticated enough to understand the risks and be able to interpret the accuracy and completeness of any performance information on their own.
RCM receives a portion of the commodity brokerage commissions you pay in connection with your futures trading and/or a portion of the interest income (if any) earned on an account's assets. The listed manager may also pay RCM a portion of the fees they receive from accounts introduced to them by RCM.