Musings on Trade Wars

(Edited from commentary by Larry Swedroe, Director of Research for The BAM Alliance)

SwedroeFor some time now, investors have been very concerned about the potential for a global trade war – a war in which there are not any real winners. That, of course, worries investors, especially those who were taught that the Smoot Hawley Tariffs enacted in 1930 was a major contributor to the Great Depression. While it certainly did not help, the causes of the Great Depression go way beyond tariffs, and the depth of the depression is mostly attributed to poor monetary and fiscal policy decisions by Central Bankers around the globe. The concerns have left many wondering what (if anything) they should do.

First, whenever an investor is concerned about any issue, they should stop and ask themselves this question: Am I the only one who knows about this? Clearly the answer is going to be no. As believers of the idea that market prices already reflect all publicly known information, it is reasonable to discern that stock markets not only reflect what we are reading in the news, but also the odds of these events actually occurring. Thus, unless you somehow believe that you know more than the collective wisdom of all the institutional investment managers, hedge funds and mutual fund professionals (who do about 90% of the trading, and thus set prices), it is too late to act.

Second, ask yourself if you think folks like Warren Buffet are aware of the situation. Again, the answer will surely be yes, and he isn’t doing any selling. Unless you believe you are smarter than Buffett, it is wise to take his advice and avoid trying to time the market.

Third, seek real analysis on the impact, not the opinions of talking heads on the television. Oxford Economics, a global leader in economic analysis and forecasting, calculated the tariffs with China would shave 0.1% – 0.3% off of GDP the next two years. This is a far, far cry from the doomsday scenarios being painted by the news media. We must reiterate here that forecasts are rarely perfectly accurate, but it undermines the reality that the results of a trade war are likely less than most believe.

Fourth, remember that the overwhelming evidence is that active managers are highly unlikely to generate alpha by timing the market (or picking stocks, like those that will benefit from a trade war and avoiding those that will suffer the most). Over the last 15 years, the DFA funds we have utilized (which have ignored all the economic and geopolitical news), have outperformed 90% of all active funds, on average. We’ll take those odds anytime. And why would anyone want to take the other side of that bet?

Finally, there are a few things we can say, but that does not necessarily mean they are absolute. Relatively speaking, in a trade war, the US tends to do better because trade is a much smaller percentage of our GNP than it is for most countries. Small stocks also tend to do better because they tend to be less exposed to world trade. And the dollar tends to strengthen due to flight to safety and liquidity.

Conversely, international stocks tend to perform worse, and emerging markets the worst of all because their economies (a) tend to be more reliant on globe trade, (b) their currencies take a hit from flight to safety, and (c) their debt tends to be in dollars (which are appreciating).

Over the last several months, this is exactly what has already happened as the risks of a trade war increased. When the market thinks the odds of a trade war go up, you see more of this type of action. Then, when the odds seem less, the reverse occurs.

Emerging market stocks started this year with a bang, but have retreated sharply to a point where they are well into the negative. Meanwhile, small stocks in the US are outperforming. And it is likely also why Treasury bond yields have recently come well off their highest levels (Treasury bonds benefit from the flight to safety and liquidity).

But again, all of this information was already reflected in stock prices by the time the news media had picked-up on it, and we simply just don’t know how the game will end. Plenty of people out there have opinions, but virtually none of it is rooted in relevent facts. This is an unprecedented set of circumstances.

If the president’s strategy of confronting our partners works, and tariffs around the globe ultimately come down, it will be a huge win for the entire world, not just the US. In that case, stock prices would likely rebound sharply, while bond yields likely would rise. International stocks would likely do better than the US, and emerging markets would recover the most. Of course, that is an all else equal kind of thing and all else is never equal.

On the other hand, if it turns into an all-out war and tariffs remain in place for the foreseeable future, it would likely lead to lower economic growth around the world, with the US least impacted. That would likely forestall any further Fed rate hikes as they become concerned about growth.

It could also lead to spikes in inflation. Not only would the costs of many imports rise, the competition for domestic producers would be lessened, allowing them to raise prices. Some industries would benefit, such as the domestic steel producers and their workers that have been referenced regularly the last several years. However, other related industries lose big as the cost of steel rises, raising prices on all types of products from cars to canned goods.

This is ultimately why no one wins trade wars in the end. President Trump’s tweet suggesting that trade wars are easy to win is misleading, at best, and quite dangerous if taken in the literal sense. That said, with the backing of a strong economy, low unemployment, a relatively strong dollar, and the fact that the US is less reliant on foreign trade than our trade partners, the US holds an extremely strong position in the threat of a trade war.

During his campaign, Trump promised that he would not waste American lives and treasure in pointless wars of choice. A true trade war could turn into his Afghanistan. Hopefully cooler heads around the world (including domestically) will prevail, and an all-out trade war can be avoided. Currently, we are only in the early innings.

The bottom line for your own personal economy is that investors should build the risks of such events into their plans and asset allocation in the first place, which is something we do with each and every one of you. If issues like these lead an investor to panicked selling, they have too much equity exposure to begin with.

At the end of the day, investors need to learn to differentiate information (there is possibility of a trade war) from what is called value relevant information (which you can exploit because others either are unaware or you can interpret better). In virtually all cases, any economic or geopolitical news is information, but not value relevant unless you have a copy of tomorrow’s newspaper.