Tariffs are the trump card for the US midterm elections
- After his performance in Helsinki, President Trump faces the inevitable loss of the House of Representatives at the US midterm elections.
- Trade and tariffs has been one issue that have boosted his popularity this year.
- Markets have dismissed geopolitical risks because the current growth and profits outlook has been compelling. Hence, dips keep getting bought.
- That said, multiples won’t expand with so many medium term, global headwinds (Trade, Brexit, Italy, Idiosyncratic EM concerns)
- With MSCI World up 3.8% in the past three weeks, it is a compelling, tactical risk v reward to sell equities. The thematic model portfolio going from 60% net long equities to 20%
For anyone who has access to cable news, it is difficult to not look at the display by President Trump in Helsinki and think about the eventual negative impact of a US President so at odds with the office for which he serves. However, one always needs to take a breath and focus on what has taken us to all-time highs in the NASDAQ and there or thereabouts for other US indices. As a client succinctly articulated to me on Tuesday, markets are incapable of pricing, in a differentiated way, macro / geo-political risk. I would put it slightly differently and that is that the only thing that matters is data and from a growth and profits perspective, the US has been fine, the EU is bottoming, and China is marginally softer. Future problems such as tariffs, Italy, Brexit, and idiosyncratic emerging market problems are for the future and until they directly start to upend the relatively rosy outlook for growth and profits, the market’s response will be minor before a yield hungry world continues to add to the same high-quality companies and credits that they have focused on for the past several years. For the balance of the summer, it still appears to be this simple.
Is the pound falling because Brexit fears are becoming real or because the data this week has been soft, threatening the inevitability of an August rate increase by the Bank of England? Trade concerns will only escalate yet US assets, even the inevitable victims of Chinese retaliation, are close to historic highs. The reality is that tariffs are currently insignificant and have only been enforced for a couple of weeks. Fed Chairman Powell’s blasé reaction to questions about trade are justified because a) there is nothing he can do about it, b) it hasn’t impacted the data as yet, and c) the economic impacts cannot be currently quantified. Why would he take the risk altering policy for factors he cannot determine? Despite this implying that US rates will rise as expected, the predictability of the path of interest rates is more positive for equity and credit markets than any uncertainty over the trajectory of rates. Those pundits who believe the Fed could pause because of tariff rhetoric miss the point both in terms of Fed policy itself and the market’s medium-term response function.
Are we a “buy on dips world” or a “sell on rallies world”? The answer to that is; both.
While growth and profits remain solid, selling on the back of geo-political shocks is merely an exercise in multiple contraction and as such, companies with strong, stable cash flows will eventually be bought. We have seen this time and again in recent months regarding trade. President Trump amplifies the bluster, tensions rise, and global equity and credit markets take a hit. However, corrections across the globe, with the exception of EM, have been muted. Twitter, as a policy tool, doesn’t hurt the profit outlook over the next few quarters. Perversely, there is evidence of US multi-nationals, fearing trade reprisals, easing back on capex and starting to increase share buybacks. The result is higher share prices. While it can be argued that the global technology and consumer companies around the globe that people want to own are not cheap by any metric, the wholesale selling of equity and credit markets, broadly the risk asset bucket, will not occur while profits are solid, inflation isn’t a threat, and interest rates are orderly. There is nothing, near term, on the geo-political horizon that can derail this.
The President of the United States sided with the Russian President over foreign tampering in a democratic election and markets didn’t blip. This is all you need to know about geo-political risk. It doesn’t matter until it affects economic activity.
All that said, geopolitics does affect sentiment or more specifically, the multiple that investors are prepared to pay for all assets, both public and private. While profit guidance today is meaning that multiples are supported at lower levels, this should not imply that equity multiples will expand or that credit markets will continue to tighten. Policy risk will definitely make investors think twice before paying a higher multiple than what is prevailing if the chance of an extra $200bn of additional tariffs on China come to fruition, if the Italian government could blow out its budget in Q4, or the UK could crash out of the European Union without a deal. Buying current cashflows at a discount to current levels (buying dips) is one thing, but to pay a higher multiple for equity or a tighter spread for credit implies an investor either a) is compelled to buy for mandate reasons, or b) they have to be supremely confident that the growth and earnings outlook is assured, something that is next to impossible given the geo-political backdrop. Buying dips gives you some cushion, some margin for error because you are acquiring assets cheaper. Buying strength does not afford you that luxury.
So, in equity and credit markets, developed and to some extent emerging, we are caught between markets where investors who will buy dips but where the upside is limited. The nervous will sell, but buyers will be cautious as stocks rally. While short carry strategies can be problematic over the summer doldrums, multiples will not expand with the market facing an array of medium term uncertainties. While Brexit and Italy will steal the headlines as we head into Q4, it will be a harsh escalation in trade tension that will cap multiples and lead to another opportunity for investors buy the companies / credits they like at cheaper valuations.
Tariffs are President Trump’s weapon for the mid-terms
Free marketeers can complain all they like but there is very little doubt that tariffs are popular with President Trump’s base. It is plain to see that his economic nationalist policies have led to a bump in President Trump’s approval ratings since the rhetoric was beefed up earlier this year. The tax cuts have also been supported by the Republican base, rich and poor alike, tough trade talk against China and the EU in general have been applauded. The tribal nature of American politics implies that effectively nothing President Trump does is ever frowned upon by the base, but one gets the sense that if President Trump is going to prevent the House of Representatives from heading back into Democrat hands, trade could be a marque issue. The following chart is from Axios and shows, a) how Republicans believe the President Trump can do nothing wrong, but b) and more importantly, how independent voters are against the President in this major issue and he will need these independent voters to hold the House of Representatives.
The super bearish argument for markets is that the President’s popularity amongst independents could plummet and put the Senate and therefore impeachment in play. This is probably a bridge too far and political suicide for a Democratic Party fighting with its own disfunctions. The more realistic scenario, according the latest polling and the lack of tightly held Republican Senate seats that are being contested, is that the Republicans hold the Senate. That said, for President Trump to keep the House and ensure his legislative agenda and more importantly, any potential future conservative Supreme Court candidates to have smooth confirmations, his approval ratings cannot fall, and on the surface, it appears his popularity will fall in response to the way he handled his meeting with Mr. Putin.
So, how does the President stop his popularity from plummeting? Well, one way is to focus on what has worked for him, and that is to focus on trade and tariffs. China and to a lesser extent, the European Union, are soft targets when it comes to trade and with the free market wing of the Republican Party silent regarding criticism of economic policy that, everyone agrees, will hurt US and global growth, there is nothing to stop the President and his band of economic nationalists led by Ambassador Lighthizer and “Economist????” Peter Navarro, from pushing forward with their “America First” agenda. It is difficult to see how European auto tariffs are not implemented and additional tariffs against China seem inevitable.
The market’s response will be predictable. A short sharp selloff only to see buyers re-emerge. However, more importantly, from a tactical standpoint, the risk reward of shorting stocks or at minimum, reducing equity exposure is extremely compelling. With MSCI World rallying 3.8% in the past three weeks, the chance of dramatic new highs given the likelihood of a worsening in trade tensions is unlikely, despite what is likely to be a solid US earnings season.
If you wanted evidence that we are living in a range bound world for global stocks in the aggregate, MSCI world shows you this.
The thematic model portfolio is currently 60% net long equity with a large bias towards emerging market equity. While I believe strongly that China bearishness is excessive, and that EM underperformance is coming to an end, all equity markets will suffer if President Trump uses trade as a political tool going into the mid-term elections. Upon the release of this report, the thematic model portfolio will drop our net equity exposure to 20% via a combination of the following:
· Sell a 20% position in the SPX above 2800
· Sell a 10% position to close in EEM to reduce leverage
· Sell a new 10% position in Taiwan equities to hedge China trade risks
Why Taiwan and why now?
Taiwan is one of those markets that doesn’t often appear on the radar screen but given where we are regarding tariffs, the scenario I will outline is compelling. The outperformance of Taiwan equities versus China and frankly, the rest of Asia has been telling, especially when you consider that foreign investors have sold close to $10bn in equities so far in 2018. Clearly domestic investors are seeing something that foreigners are not and while a persuasive rule in emerging markets is to follow what locals are doing, markets like Taiwan are not immune to the gyrations of global beta.
$200bn of additional tariffs must hurt the technology supply chain, it is impossible to see how it doesn’t. With the thematic portfolio long an array of Chinese technology companies we are effectively establishing a long China / short Taiwan strategy for the next couple of months. Tactically, the rationale is as follows:
If President Trump ramps up trade tensions by implementing the $200bn he has been threatening to, then Asian equity takes a big hit and Taiwan will not be immune. That said, while China equity will be capped, I do not see much additional downside as they are well through the adjustment process. With the Taiwanese equity having outperformed the Shanghai Composite by 18% so far this year, there is plenty of room for catch up.
If I am wrong on tariffs and cooler heads prevail, Chinese equities should rebound sharply. I am firmly in the camp that Beijing is in the process of undertaking a triple stimulus that involves monetary easing, a trade weighted weakening of the currency, and a fiscal spending program targeting SMEs. It was interesting to note that China has just announced the loosening of rules for banks regarding the asset management industry. This is very constructive, and I believe all part of making the transition of moving assets away from shadow banking and poorly regulated wealth management products back onto balance sheet, that much smother. The lessening of trade tensions will be one less headwind for this evolving economy to handle.
Under this rosy but less likely scenario, buoyant Taiwanese assets should lag as investor rotate into a much cheaper China. I concede that some of the money that left Taiwan in H1 2018 could return, but the compelling nature of Chinese equities should see the performance differential between the two markets contract regardless.
All that said, given the tactical nature of this trade which I believe should play out over the next eight weeks, it is difficult for me to see how trade tensions ease during this shorter time frame.
The significant reduction in equity exposure is a function of what I believe is the inevitable increase in tariffs by President Trump to improve his chances of holding the House of Representatives at November’s mid-term elections. I do find it very difficult to see how this scenario doesn’t play out, and therefore the rally we have witnessed in global equites in recent weeks should reverse. With US earnings season ending over the course of the next week or so, the catalyst for higher equity prices based on confirmation of earnings strength disappears. Markets will be back focusing on headlines and while the global growth outlook remains constructive and the data is in reasonable shape, geo-political headlines will continue to be a drag on sentiment