Trade Wars, Tariffs, Stocks And The Definition Of 'Winning'

Is this what "winning" looks like?
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At the current juncture, it's hard to say with any degree of conviction what the actual point of Donald Trump's burgeoning trade war with the rest of creation is.

We really won't know how much of this is a political gambit and how much of it stems from an actual desire to reshape the global trade order until after the midterms.

According to at least one analyst, nearly all roads lead to at least some permanent tariffs. "If tariffs are strategic, reflecting a shift towards a change in global economic policies, they should persist irrespective of short-term political developments," Deutsche Bank's Aleksandar Kocic wrote, in a note dated last Friday.

Complicating things is the fact (because that's what it is - a fact) that Trump himself couldn't put a number on things if you asked him to tell you how much of his bluster is motivated by real economic concerns and how much is inspired by a desire to rally the base of November. Importantly, the fact that Trump couldn't answer that question isn't completely down to ineptitude. Rather, having tipped the first couple of dominos, what happens from here isn't entirely up to him. Paradoxically, by trying to take the reins, he's relinquished some of his control. Even if he plans to "only" do X, those plans could be derailed if China (or Europe or Canada or Mexico or [fill in the blank]) decides to do Y, where Y is something other than what Trump was using to justify X.

In other words, each escalation raises the stakes by increasing the chances of miscalculation on all sides. So even if you assume that Trump is entirely motivated by political concerns, it's possible that China could do something drastic enough that the fallout would force the administration to start thinking in terms of markets and economics.

On the markets front, Trump appears to be "winning", if you define "winning" narrowly and couch it in terms of equity outperformance.

I'm not sure whether he realizes it or not, but between his fiscal policies and the trade tensions, he's engineered a perfect storm for emerging assets and European equities.

Fiscal stimulus raises the odds of an inflation overshoot, prompting the Fed to lean more hawkish than they otherwise might. Meanwhile, the deluge of Treasury supply needed to fund that stimulus is colliding with Fed balance sheet rundown to create a dollar liquidity shortage outside of the U.S. debt market. Exactly none of that is good for emerging market assets.

For Europe, the trade tension comes at a particularly inopportune time. Eurozone economic activity decelerated notably in Q1 and if that downturn proves to be something other than transitory, well then the trade friction with the U.S. could exacerbate it and derail the ECB's plans to normalize policy. Throw in a dash of Italian populist seasoning, and you've got a particularly tenuous situation across the pond.

The timing of the trade war leaves a lot to be desired in China as well. Officials are attempting to engineer a soft landing by carefully calibrating the deleveraging effort in a way that doesn't risk choking off credit creation in the real economy. Recently, the data has rolled over a bit and that's prompted the PBoC to resort to RRR cuts in an effort to ensure liquidity remains ample. In short: even without the trade war, a policy divergence narrative was building between the Fed and the PBoC. Now, that narrative is likely to gather strength as the Fed sticks to its guns (emboldened by solid data stateside and the threat of inflation) and the PBoC attempts to bolster the domestic economy.

The end result: Q2 was the worst quarter for emerging market equities and FX since 2015; Chinese equities are mired in a bear market and have fallen for seven consecutive weeks; the Chinese yuan is depreciating at the fastest pace since the devaluation; European financials are laid low; and European automakers have plunged 17% from the highs in January.

Have a look at an 8-week rolling flows chart for EM and European equity funds (from BofAML):

FlowsEMEurope

In the same vein, foreign money is fleeing Asian equities at the 3rd fastest pace in 16 years, according to Goldman:

OutflowsAsia

Meanwhile, the Russell 2000 and the Nasdaq are still sitting near record highs, with both rallying sharply to close the week after June payrolls continued to suggest that the sugar high from late-cycle fiscal stimulus has yet to fade.

Perhaps the clearest example of the growing disparity between U.S. equities and their international counterparts is the Shanghai Composite/S&P ratio, which is sitting at its lowest levels since 2006:

ratio

Is this what "winning" looks like?

Well, again, that depends on what one's definition of "winning" is. It's certainly what "America first" looks like.

At the end of the day, though, the interconnectedness of global markets and, more to the point when it comes to trade, global supply chains, means that this strategy is doomed. Friday's BMW news was a case in point.

While some countries may be entirely surrounded by "big water, ocean water", Trump would do well to remember that in a figurative sense, globalization means that no country, like no man, is an island.

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