Trade wars and threatening to start them are all the hype at the moment, it seems. Stock markets had a rough patch in late February to early March 2018 when the US President proclaimed on Twitter that trade wars are “good, and easy to win” and proposed 25% tariffs on steel and 10% tariffs on aluminum imports.
In the next days the headlines on imposing tariffs on Chinese technology became increasingly frequent. In both cases bureaucrats in China and the European Union took note and predictably went into battle mode rather quickly. When tariffs were finally announced, markets swooned again.
A trade war refers to two or more states raising or creating tariffs or other trade barriers on each other in retaliation for other trade barriers. Increased protection causes both nations’ output compositions to move towards their autarky position. (Source: Wikipedia)
Coping with the onset of a trade war requires some ingenuity by investors. It requires answering questions such as which sectors are likely to benefit from protectionism and which sectors are likely to get hurt. Or whether the negative impact on the economy as a whole is bad enough to offset or exacerbate the impact on individual sectors. And whether short-term protectionism of a dying industry will really help that over the long run (after all, I am not a day trader).
Every case is going to be different, but here I will focus on the increasing trade issues between China and the US.
China vs. America: who exports what?
As of writing, the looming threat is that of a full-blown trade war between China and the US, with much of the rest of the world spared of Trump’s wrath. Ignoring the day to day headlines of what sectors may be targeted directly, let’s look at what products US-China trade is composed of:
- The US exported $169.8 billion worth of goods and services to China in 2016, while China exported $478.8 back to the US, making it America’s largest trading partner
- The main export categories from the US to China were misc. grains, seeds and fruits ($15 billion), aircraft ($15 billion), electrical machinery ($12 billion), machinery ($11 billion) and vehicles ($11 billion). Within agricultural products, soybeans and pork related products stand out.
- On the other hand, the US mainly imported electrical machinery ($129 billion), machinery ($97 billion), furniture and bedding ($29 billion), toys and shoes. Within agriculture, fruits and juices stand out
So in all one would expect Chinese technology and machinery to suffer, while soybean, pork and aircraft producers could do well and their American counterparts would suffer. Foreign technology producers that export to the US but are based outside of China may benefit while similarly US manufacturing in slowly dying industries may see a temporary boost.
How would financial markets respond to a trade war?
Leaving the economics and politics of it all aside for a second, one thing is fairly clear: financial markets do not like anything that can have a negative impact on trade and global economic growth. When two heavyweights like China and America face off, consequences are likely to be felt in almost every part of the world.
In the period of 26 February to 1 March 2018 the S&P lost -3.7%, though it quickly gained most of that back in the days immediately after as markets processed Donald Trump’s bluster (and it turned out that every country and their grandmother could potentially get an exemption). At the end of March, indices again went down nearly -3% on announcement of tariffs on Chinese technology.
A brief trade war – one move and one counter move – that hits a few specific sectors will annoy markets and hurt for a few days (export-dependent companies in those sectors especially so), and blow over. Risk-off assets like gold and Japanese yen will perform well for a bit before returning to their means, while specific sectors may either be hit or benefit from all the turmoil. A prolonged trade war with tit-for-tat retaliation in a downwards spiral could be a whole different story and could be the cause for the next long term equity bear market.
So how will it all play out if it does happen?
Essentially I’d expect three things to play out during any trade war and all the negative news headlines that trade wars will bring along with it.
- Flight to safety: There will be a flight to quality in financial markets, likely short-lived but possibly pushing up or down the equilibrium levels of some safe-haven assets in the medium term. That means that as always, you will see a stronger Japanese yen and Swiss franc, gains in gold and positive returns on US Treasuries. At the same time, the US dollar may strengthen and equities and emerging market currencies will sell off hard. Typically this doesn’t persist for much longer than a few days, unless lasting economic damage and negative spillover to other sectors is expected.
- Direct hits: The sectors that are positively or negatively affected will show outsized returns. In this case it appears that US steel and aluminum producers may benefit, as will Chinese soybean and pork producers. In the case of tariffs on Chinese technology, those companies will be directly hit while the tech sectors of countries like Japan and South Korea may actually benefit.
- Indirect misses: Companies that are largely dependent on foreign markets, whether these are US, European or Asian companies, will sell off indiscriminately. Companies whose profits are mostly derived from their home markets will go down with the market, but will look relatively better than their peers. It should be noted that many of those companies will be small caps
The difficulty is that it is quite likely that the drag on the economy from tariffs is seen as so significant that the market beta is going to have the overwhelming effect on stocks. You may be able to find stocks that do better than their peers based on the above, but they might still sell off if only to a smaller extent. Even in the case of risk-off assets like US Treasuries there are caveats. China is the biggest holder of these bonds and in case of tit-for-tat retaliations could decide to dump them sparking large losses.
Finally, inflation linked assets like TIPS and commodities may do well as trade wars tend to increase prices.
How likely is this theme to actually play out?
It is very hard to say how trigger happy the American government is really going to be when it comes to this matter. Perhaps it is all a negotiating tactic, or perhaps not. It is equally unsure how other countries will respond. They want to be tough, but that toughness may come at the expense of their own economies.
While Trump is increasingly surrounded by hardliners which may push him to take action, we also know that Trump cares deeply about the stock market. All in all I therefore assign a low 10% to 20% probability to this actually affecting markets in a significant way. I would put a max of 5%-10% in below sub-portfolio for the duration of Trump’s obsessive focus on trade imbalances.
Portfolio construction: risk-off, commodities and trade shielded equities
- I constructed a portfolio consisting of 5 ETFs, focused on dealing with a China-US trade war without positioning too specifically for how that would play out. This portfolio is 30% long US and China small caps, has 45% classic risk-off assets such as long JPY and US Treasuries, while the remaining 25% is put into inflation-sensitive commodities
- The below table shows the portfolio characteristics. We are looking at a dividend of 2.3%, while the volatility is estimated to be 6.0% on an ex-ante basis
|US Small Cap||iShares Russell 2000 ETF||IWM||0.20%||15.0%|
|China Small Cap||Guggenheim China Small Cap ETF||HAO||0.75%||15.0%|
|Long JPY||ETFS Long JPY Short USD ETF||LJPY||0.39%||30.0%|
|US Treasury||iShares 7-10 Year Treasury ETF||IEF||0.15%||15.0%|
|Commodity||iShares Commodities Select Strategy ETF||COMT||0.48%||25.0%|
Risk, diversification and allocation
- Risk level: high
- Diversification: medium
- For risk and total return since initiation see Portfolios
- Probability of this theme playing out in the next 3-10 years: 10%-20%
Portfolio characteristics (full look-through, from USD perspective)
- Dividend yield: 2.30%
- Ex-ante predicted volatility: 6.0%
- 1 year 95% Value-at-Risk: –8.3%
- Scenario: 2008 Lehman Brothers default period: -12.0%
- Scenario Interest rates +100bps: -0.9%
- Scenario 2008-2009: -5.7%
- Scenario 2010 onwards: +87%