Trade War Delirium: We're All Afflicted

The Heisenberg profile picture
The Heisenberg


  • Unfortunately, we're all stuck in an echo chamber when it comes to market moving news about trade tensions.
  • Making sense of things can be quite challenging and recent underperformance on the part of traditional safe havens only complicates things for asset allocators.
  • Analysts are divided about economic spillover risk, but one thing seems certain: the interconnectedness of modern markets makes financial spillovers inevitable.
  • One bank reminds you that trade banter preceded the 1987 crash, while one trader cautions that even lucky bears who called Black Monday would have suffered mightily in the lead up.

I talk to a lot of financial journalists and as regular readers know, I also talk to a lot of traders and analysts at the banks.

While I'm sure the higher-ups at the major media outlets are enjoying the trade war circus to the extent it gives them fodder for stories, and while increased volatility across capital markets is a welcome sign for the big banks whose trading revenues slumped during the market calm, I know at least some journalists and analysts who would be just fine with it if the trade tension abated for a week, or for a month, or altogether entirely.

Markets and those who cover them are stuck in a kind of echo chamber where you can't not talk about the burgeoning global trade war. The problem is that the more the media talks about it, the more inclined the Trump administration is to try and manage the message, which means giving the media more soundbites to key on. The more the administration talks, the more compelled America's trade partners feel to respond and those responses elicit still more media coverage and more headlines. Those headlines move markets and when markets move, analysts have to interpret those moves on the way to making predictions about what comes next.

We got another example of this over the weekend when, in the course of a wide-ranging interview with CBS’s Jeff Glor, Trump described the European Union as a "foe" of the United States. Additionally, in a rather bombastic interview with The Sun released Friday, the President suggested that Theresa May's Brexit approach could "kill" a bilateral trade deal between the U.S. and the U.K.

This self-referential dynamic has created a merry-go-round, wherein it's impossible to discern what is chicken and what is egg, what is cart and what is horse. As we've seen over the past several months, this is conducive to escalations on the trade front. Things get taken out of context, one side or the other miscalculates and modern market structure means headlines are parsed immediately by algos "who" trade first and "ask" questions later or, worse, pull back from providing liquidity on the assumption something is going on that a machine isn't capable of parsing (that's the "adverse selection" scenario Goldman (GS) warned about in a high profile series of notes earlier this year).

Unfortunately, there's no readily identifiable path out of this. Most analysts seem to believe that the USTR's decision to publish a list in conjunction with prospective tariffs on another $200 billion in Chinese goods marked the proverbial point of no return. I'm not sure I would couch it in those terms, but the main problem with that decision is that it potentially pushes us above the threshold beyond which China cannot respond with reciprocal tariffs. That means they'll have to resort to other, more "creative" measures. That, in turn, opens the door for further miscalculation because depending on what combination of measures Beijing decides to go with, it could be difficult for the Trump administration to figure out what would count as a "proportionate" response, especially if China resorts to qualitative measures, like using North Korea as leverage.

So, we're all going to be stuck talking about trade for the foreseeable future and on Friday, Goldman was out lifting their odds that the tariffs on the additional $200 billion in Chinese goods will indeed become a reality. The bank kept their subjective odds of the auto tariffs at a comparatively low 35%, but if you just step back and look at how far we've come on this since January, it's truly remarkable. Here's a useful infographic from the Goldman note for anyone who might have missed it:


The unfortunate thing about all of this for large allocators of capital (beyond the obvious angst that goes along with having to wonder what kind of headlines they're going to wake up to) is that it's not entirely clear where the "safe havens" are.

Gold (GLD) is sitting near one-year lows as hawkish Fed policy, a stronger dollar (UUP) and rising U.S. short rates weigh on demand. The yen (FXY) is actually the worst-performing G-10 currency in July, a state of affairs that's confusing some investors. And the bullish case for U.S. small caps (IWM) amid the trade tensions (the outperformance of the Russell 2000 has been variously attributed to small caps' relatively low international revenue exposure) was called into question this month by Barclays (BCS) and Morgan Stanley (MS). Specifically, Barclays suggested that small caps are in fact more exposed to tariffs than their large-cap cousins (and they've done the math, so argue at your own peril). For their part, Morgan Stanley took a simpler approach, writing the following in a recent note on the way to cutting small caps from overweight to equal-weight:

[While] the bull case makes sense intuitively, US-centric small cap companies would [not] be immune to a major escalation in trade tensions, which would ultimately be a significant drag on the US economy, too.

In short (get it?), you've got to wonder about the durability of this:


That last point from Morgan Stanley (that a major escalation in trade tensions would spill over and threaten to derail economic momentum in the U.S.) is the subject of vociferous debate. Notably, Goldman doesn't agree, writing the following in a new note:

Historically the US has been fairly immune to foreign spillovers. According to our analysis of the historical causes of US recessions, it has been about a century since the US last ‘imported’ a recession via weak global demand or financial contagion.

That said, the bank does caution that thanks to the interconnectedness of global markets, the risk of financial contagion (e.g., turmoil in global equity markets spilling over into U.S. stocks) is now greater than ever. There's more than a little irony in that setup and for those who appreciate irony in a world where it's all but dead, you can read more details here, but for our purposes, just note that this is the same point I made weeks ago in a post for this platform called "America First." You'll forgive me if I quote myself:

It's the U.S. versus the rest of the world at this juncture when it comes to markets and what I would encourage investors to keep in mind is the fact that markets are more interconnected than they've ever been. That interconnectedness is mirrored in global supply chains and all other aspects of global trade and commerce.

I want to remind you that in addition to "honest" financial market spillovers that result from the interconnectedness of global markets, modern market structure makes "accidental" spillovers more likely. This harkens back to the "adverse selection" issue mentioned above. Simply put, HFTs can't process certain types of news because they're machines. And so, when they "suspect" something is amiss that they aren't capable of grasping, they just get out of Dodge. Here's Goldman, from a May note:

A recent report on the behavior of HFTs in the Eurex Bund Futures market around high-impact macroeconomic news announcements suggests precisely this—that HFTs systematically withdraw liquidity when “complex” (non-routine) information is known to be in the market. Exhibit 4 is borrowed from this report and shows how HFTs behave during the 60-minute interval around major news events. The left chart shows that the overall depth in the market declines sharply around the announcement time (around 70% on average). The right chart displays the participation rate by HFTs, which declines from around 50% 10 minutes before the announcement to 33% at the time of release. This is also a drop of around 70%, suggesting that the drop in market depth is due mainly to the retreat of HFTs.

If that's what HFTs are prone to doing around macroeconomic news, it seems entirely reasonable to suggest that the potential exists for even more acute liquidity vacuums around trade headlines which are infinitely more difficult to parse for nuance than any macro release.

While analysts have generally been reluctant to come to terms with the increased risk of a worst-case scenario when it comes to trade, a more sobering tone is starting to creep into some of these notes. Take this brief excerpt from a Barclays piece dated Friday, for instance:

Although it may still hold true that all these moves remain just part of Trump’s negotiation strategy, especially against the backdrop of the important US mid-term elections in November, this week’s events imply a further escalation. Market reactions thus far still reflect the benign consensus view of a very limited effect from these trade frictions. However, these could change abruptly, as they typically do. In a modern world of global value chains, much of trade is imports and reexports of intermediate goods as they go through processing nodes before reaching the final consumers. Tariffs and other trade costs thus create cascading effects, potentially disrupting the global trading system much more than the comparison of each single tariff’s value with the value of global GDP would suggest. Moreover, these effects are likely to be nonlinear, as agents initially remain in a wait-and-see mode; but once sentiment deteriorates and expectations adjust, the effect on trade and investment flows fully kicks in.

In that same note, the bank rolls out the following visual and yes, it's a 1987 reference:


That will invariably elicit eye rolls from readers and rightfully so. 1987 comparisons are a bit of a cheap shot and if you're really trying hard enough, you can always figure out a way to conjure up a Black Monday analog.

That said, Barclays isn't trying to scare you there. That visual is from the latest installment of their "Global Economics Weekly" series which, as you can probably imagine given the title, isn't the type of publication people look to when it comes to riveting tales of market crashes and other types of bearish balderdash. Rather, the point there is just to underscore the fact that epochal shifts in global trade are a big deal with the potential to move markets and given how far the world has come in terms of globalization, a concerted effort to roll things back risks roiling global assets, almost by definition.

Do take a second to appreciate that exactly none of the above is meant to suggest that there are any real "fundamental" problems here. In fact, virtually every risk factor outlined in this post is in one way or another of our own making (and by "our" I mean we, as a planet full of human beings). The trade tension isn't necessary, the risk of miscalculation could be mitigated materially by face-to-face, good faith negotiations, the media could eschew a tendency to chase every headline in favor of an approach that seeks to prioritize the most important aspects of the trade situation, and market participants could decide that enough is enough when it comes to the proliferation of HFTs across market making.

Alas, none of that is going to happen, so for those of you who are actively managing money and/or allocating capital (either for yourself or on behalf of others) you're stuck with the current situation in which you're compelled to try and make sense of an inherently nonsensical trade dispute. I wish you the best of luck in that regard.

Finally, to close on a bullish note, my friend Kevin Muir (a former equity derivatives trader at RBC Dominion Securities and current head of research at East West Investment Management), reminds you that even if you called the biggest crash in history months in advance, bears had a tough go of it waiting for that fateful day to finally come:

During the summer of 1987, the stock market rallied 17.5% while the 10-year US Treasury yield was stuck in a trading range between 8.25% and 8.90%. It wasn’t until the bond market sold off hard in September, with the 10-year yield rising from 9% to 10.25% in less than two months, that the stock market finally went down. The point to remember is that the stock market was less than one calendar quarter away from the biggest one day decline in history, but any shorts would have had to sit through an almost 20% rise before realizing the gains from their bearish call.

(Bloomberg, Kevin Muir)

This article was written by

The Heisenberg profile picture
Perhaps more than any other time in the last six decades, the fate of markets is inextricably intertwined with the ebb and flow of geopolitics. It's become increasingly clear that one simply cannot fully comprehend market movements without a thorough understanding of concurrent political outcomes. Drawing on extensive experience in both politics and finance, Heisenberg will help demystify a world in which investors can no longer hope to conceptualize of markets as existing in anything that even approximates a vacuum.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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