By Kevin Muir
By necessity, today’s topic will venture into the world of politics, so I warn you now – you might be offended. Actually, I have decided to cut jabs at all politicians, so if you feel like your team has been maligned, just read on, I will probably be even worse to the other side.
I want to speak about the recent “trade wars” that the Trump administration has set in motion. There can be no denying that America has ventured down a road of adversarial trade renegotiations not seen in decades. I am not making any judgments about this policy – it is what it is. But to think it doesn’t have profound implications for your portfolio would be naive.
What I used to think
Previously, I believed America’s trade stance was just Trump doing his “Art of the Deal” negotiations. You know – insult your opponent, be belligerent and take extreme stances right until the very end, at which point you just cut the best deal available.
It seemed to me that Trump was simply renegotiating all the trade deals to gain the maximum advantage. He was elected on a populist platform and he considers himself quite the deal-maker, so I thought it would be a little rocky, but that at the end of the day, deals would be reached and the result would be a slight shift a little more in America’s favour.
Yet I am rethinking that viewpoint and let me tell you why.
Collision course with China
Let’s start with the obvious. Trump can insult Canadian leader Justin Trudeau all he wants, but it won’t stop us Canadians from making a deal. Sure, we won’t like it, but we will bite our lip and negotiate the best agreement possible.
Yet Trump’s tactics don’t play as well in China. In Asia, saving face is much more important, and it is foolish to believe the Chinese government will be anywhere near as accepting to Trump’s insults and antagonistic behaviour. Don’t forget that Chinese leader Xi has proclaimed himself “paramount leader” and can plan in decades instead of worrying about the next election cycle. For China, sitting through a couple of years more of a Trump administration without cutting a deal so that “face is saved” is completely acceptable. Especially when Trump continues to behave so disrespectfully.
Many market strategists are convinced China will be forced to acquiesce due to U.S. stocks’ outperformance versus Chinese stocks since Trump’s ramping up of trade tensions. They believe this to be a signal of America’s stronger hand.
I suggest this confidence is misplaced. Chinese response to these market moves will definitely be Rhett Bulter-ian in nature. To think the Chinese government cares about short-term Chinese stock market valuation is ridiculous.
However the same cannot be said for their opponents. Trump has consistently cheer-lead the stock market higher – taking credit for its outstanding performance.
Rightly or wrongly, he has hitched his wagon to the stock market’s fate.
If anything, Trump has exposed a flank that can be exploited. He needs the American economy (and even more importantly, the stock market) to continue outperforming the rest of the world.
So far, so good, but last week’s stock market sell off has shown how sensitive Trump is to each market tick. We weren’t even down 5% from the all-time highs before Trump was throwing Powell under the bus.
I call B.S. on the idea that China’s recent stock market underperformance means they are desperate for a deal. Not a chance. If anything, Trump’s administration needs a deal as a serious trade war could result in severe market disruption which would be much more meaningful to Republicans’ chance of relection. On the other hand, Xi has no such worry.
Trump administration steps up the pressure
This next part might be a little tin-foil-hat for many of you, but hear me out. Most strategists blame the equity market sell off on the bond market’s recent weakness. The common narrative is that we finally hit the tipping-point where interest rates affected the real economy. Maybe.
But maybe there was something more ominous going on. The stock market started sliding on October 4th.
I think it is no coincidence that this was the day that Bloomberg Business week published their big expose about Chinese hacking – “The Big Hack: How China Used a Tiny Chip to Infiltrade U.S. Companies.”
This article is a damning piece which poses serious questions regarding the security of U.S. technology due to their reliance on Chinese manufacturing. It rightfully scares the market.
In the days following the publication, all the companies cited in the article denied the story. When given a chance to rescind their claim, Bloomberg Businessweek doubled down and stood by their story citing 17 sources that confirmed the information.
So the question is; who is lying and why?
I suggest the reason that Bloomberg Businessweek was so confident about the story was that the sources were from the U.S. government. Do I think this Chinese hacking is new? Not a chance. Do I think the U.S. government has been aware of it for years and years? For sure. But they have purposely kept it quiet as it would only serve to undermine confidence in American technology companies and damage relations with the growing (and increasingly important) Chinese economy.
Yet, by publishing this article, the Trump administration was signaling the gloves were off.
China instantly understood this was a serious escalation of tensions.
I don’t know if it was the Chinese government selling U.S. assets or whether it was well-connected individuals who understood the ramifications of this development, but I believe trade tensions were the real reason for the recent stock market decline. Sure, all those other reasons cited in the media helped the decline accelerate, but many of those reasons have existed for quite some time.
What changed on October 4th was that it became clear to those who watch markets closely that the chances of a Chinese-American trade deal had greatly diminished.
Which brings us to the current environment. Both sides believe they have the upper hand. You might have an opinion about which side is right, but it doesn’t matter – all we care about are the chances of the situation escalating.
As I previously mentioned, I used to think the recent Trump aggression was merely tactics before his government cut a deal at the last moment. And although I don’t discount that possibility entirely, I now believe that outcome is less likely.
Trump has upped the ante, and the Chinese have re-raised.
In game theory, the worst setup is a situation where all players believe they have the upper hand. It usually results in both sides seeing it through right to the end (however unpleasant the final scene is).
Neither China nor the U.S. is ready to blink. Both sides think the other guy has more to lose. If that is the case, then there will be a lot more pain in the financial markets before the problem is resolved.
Time to lighten up
Over the past few months, I have been somewhat more bullish on equities than many of my hedge-fund-brethren. Yet, for the first time in a while, I am worried. I hear all sorts of calls for a year end rally that they are planning on selling into.
Could this happen? For sure. But I am not nearly as confident anymore.
And especially when it comes to the American market. It has been screaming higher versus the rest of the world for the past couple of years. It’s due for a pause.
And I think this Chinese trade war will get much worse before it gets better. All of this adds up to a market where I am willing to starting leaning to the dark side. I have been waiting to write this piece for the past couple of days because I didn’t want to sell into the hole, but we have gotten the bounce from the lows, and now the risks of the downtrend continuing are rising.
What will make me shift my mind? Obviously either side caving and coming to terms on a trade deal would cause me to abandon my thesis. Yet absent that, I think rallies should be sold.
I have a bunch of other trades that I want to implement based on this theory, but I will save that for another day… except to say, gold priced in CNH is breaking out for a reason…
Thanks for reading,
East West Investment Management
Global Select Opportunities Fund
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