As you may know, financial markets have seen an increase in volatility over the past week. The volatility can largely be attributed to a presidential tweet about the then-upcoming (since held on Friday, May 10) trade talks with China stating, in essence, that should an agreement on trade not come to fruition, tariffs on $200 billion worth of goods imported from China would increase from 10% to 25%. Though these tariffs would generate approximately $30 billion more in revenue for the U.S. Treasury over time, they also cost the financial markets about $1.3 trillion in value in just a week (and more as I write this). Today, May 13, China retaliated with a fresh set of tariffs on the U.S., sending global stock markets down sharply, and thus setting up a potential repeat of January 2018 volatility.

In this communication, I will speak to the tariffs, mainly from the perspective of portfolio stress testing, so that one may better understand how scenarios potentially play out, ranging from a good outcome (truce) to an ugly outcome where the mistakes of the 1930s are repeated and a decades’ long trend of falling tariffs is reversed. We’ll dig into these scenarios and also speak to the other factors that may have served as fuel for this volatility of late, as well as what to expect going forward.

Before we get into the conversation about trade conflicts, I thought it would be helpful to take a wider look of the stock market as measured by the S&P500 over the past two years. In the above chart, we can see a strong surge during the second half of 2017 and into early 2018, riding expectations for tax reform before the initial tariffs were announced. Though not the sole reason for the pullback at that time, tariffs did serve as a major catalyst. Since the January 2018 high, markets have retested new highs, though not without ample volatility. While the financial pundits will celebrate these newer highs, the practical thinking folks in all of us might simply observe that new highs are simply getting us back to where we were before.

Trade Conflict Stress Testing

Within our practice, we lean on bigger-picture stress testing tools from our friends at Hidden Levers to help us shape our client portfolio models. These tools help us to look at the overall financial markets from a wider lens and allow us to adjust or better shape portfolios on themes we see as more plausible.

When looking at the trade conflict between the U.S. and China (and let’s not leave out the U.S vs. Europe while we’re at it), we have used these tools to incorporate a good, bad, and ugly scenario as a means to stress test portfolios. We have included outcomes of said scenarios with a one year outlook for three simple blended index of stocks and bonds along with a pure S&P500 benchmark for comparison.

The Good Scenario – Trade War Truce

In the good scenario, the Trump administration successfully resolves the trade conflict with China. A resolution simply could result in a tabling until more “favorable” times. Within this scenario, the economic impact seems minimal, and after a brief dip, the stock market might be able to resume previous trends if underlying economic growth remains strong.

1 Year Outlook - As of 5/10/19 Equity Index: S&P500, Bond Index: Bloomberg Barclays Aggregate Bond — 1 Year Outlook - As of 5/10/19
Equity Index: S&P500, Bond Index: Bloomberg Barclays Aggregate Bond

The Bad Scenario – Muted China Response

This scenario implies that China chooses not to respond with increased tariffs of its own, albeit smaller than those of the U.S. In this scenario, the reactions tend to be more political theater, yet they can negatively affect markets due to political uncertainty and the risk of greater action. Based on most recent events, this scenario seems to be playing out for the markets, and is evidenced by the choppy markets over the past year plus.

The Ugly Scenario – Repeating the Tariff War of the 1930s

In the 1930s the Smoot-Hawley act ushered in a period of protectionist trade globally, thus adding salt to the wounds of the Great Depression, which some observers argue helped to embolden political extremism globally at that time, leading to World War II.

In the ugly scenario, China would retaliate with tariffs and by potentially selling U.S. Treasuries, thus pressuring bond markets in addition to stock markets. The U.S. would in turn levy tariffs on many countries, not just China, resulting in a global recession. Since the ’30s, tariffs globally have been on a downward trend, but it has been quite evident that protectionist rhetoric―and dare we say political extremism―is on the rise again globally.

If I were to try and handicap the most likely outcome, I would anticipate that the trade conflict will be either resolved or “tabled” before year-end 2019 and until after the U.S. presidential elections in November 2020. Given the current administration’s reliance on stock market levels as a major “grade” of its success, there likely will be little appetite for explaining the benefits of short-term market pain to folks concerned about their 401ks while eying the ballot box.

It can be challenging to time the what ifs of a trade conflict, simply because we prefer not to adjust client portfolios based on tweets. We do however see trade relations as a factor in our broader themes of symmetric inflation (tariffs are by nature inflationary) or a weakening of the global economy should this play out longer than most would prefer. For now, we observe the drama from a safe distance.

Should you have portfolios you would like us to stress test against a potential trade war or other factors, feel free to connect with us

Thank You,

Brian Aberle, CFP
President - Aberle Investment Management

Disclosure:

This communication does not constitute investment recommendations. Please consult with your financial professional for specific advice.

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Tweets and Trade Disputes