Prophets

A Trade War Will Leave Markets With Few Winners

Anyone who recommends to “stay the course” is in denial.

The bears are upset at Goldilocks.

Photographer: Jean-Francois Monier

In the childhood tale, Goldilocks ate the porridge, sat in the chair and slept in the bed until the bears showed up to settle the score. And so it was in markets last year, as each downdraft was followed by a stronger updraft as investors responded to economic and financial conditions that were just right. But this year, the bears have come home.

Equity markets have gone from placid to volatile, and “risk on” is no longer a winning bet. Strategies that generated winners in 2017 will no longer work. To paraphrase singer-songwriter Jimmy Buffet, there's been a change in latitude, so investors must change their attitudes. Make no mistake, the U.S. is now firmly entrenched in a trade war with China.

"But if China's interests are undermined and China's interests are under threat the country will take all necessary measures to defend their interests… This has been the drumbeat China has been striking since this trade war started brewing. If you want to fight we'll be there with you, if you want to talk our door is open. China does not want a trade war." -- China’s Vice-Commerce Minister Wang Shouwen

Wars begin as skirmishes. A skirmish is the first and initial contact. Then blood begins to flow, and then egos and saving face come into play and the situation worsens. That is what I have witnessed in my four decades on Wall Street, and I expect nothing different this time. Things will get rectified eventually, but in the meantime markets are in for rough sailing. Anyone who recommends to “stay the course” is in denial. The course has been changed by the winds of economic protectionism.

One potential surprise could be the reaction of the central banks. The Federal Reserve is going to change its tune about higher interest rates. The European Central Bank will not stop its quantitative easing program come September. The Bank of Japan will continue on with its QE program. The People’s Bank of China will double down on monetary easing. It will not just be investors who have to do an about face. The world’s central banks will also make a turn in response to the fighting in the financial trenches.

Bonds may end up being the winners. I would not be surprised to see 10-year U.S. Treasury note yields head back down to the 2.25 percent to 2.50 percent range, from about 2.75 percent currently, a flatter yield curve and a re-pricing of risk premiums wider against Treasuries. If the trade war is prolonged, 10-year yields could even drop to the 2 percent to 2.25 percent range as equities come under increasing downward pressure.

The most prominent trade war was ignited by the Smoot-Hawley Tariff Act of 1930, which imposed steep tariffs on roughly 20,000 imported goods. The U.S.’s main trading partners retaliated with tariffs of their own, and U.S. exports plunged 61 percent between 1929 and 1933. Also, there was a drop in gross domestic product, which was partially caused by the tariff wars of that time, and deflation, which was amplified by the effects of the trade battles. The tariffs were repealed in 1934.

I doubt the Trump administration will allow this trade battle to reach such a fevered pitch, but I am concerned just how far President Donald Trump and his “Art of the Deal” might push things. One can only hope for the usual foray then the step-backs that occurred, as predicted, when Trump first announced his aluminum and steel tariffs.

    To contact the author of this story:
    Mark Grant at mgrant69@bloomberg.net

    To contact the editor responsible for this story:
    Robert Burgess at bburgess@bloomberg.net

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