Trade wars; Who gets hurt most?

Cornerstone Macro put out several update last week on the US-China trade conflict, which we highlighted last week here. They argue that the  administration and the Chinese may have boxed themselves in, making higher tariffs the base case scenario. China making enough concessions to satisfy Trump would be hard to achieve without being seen as capitulation, they say. Investors have underestimated the risk that Trump might reject a weak deal because it is a policy failure, could hurt him politically, and arouse his protectionist instincts. US Trade Representative Lighthizer is likely to press Trump to hold out for a better deal. Separately, Cornerstone’s Roberto Perli addresses who are the main victims of a prolonged trade war.  The answer: emerging markets ex-China because the policy response from both the US and China would make the dollar stronger and weaken the CNY. They also produced an EM Vulnerability table that ranks the EM economies, and those most at risk if the tariffs escalate.


Slovakia is canary in coal mine for European GDP

Ahead of this week’s EZ GDP, MI2 Partners argue that investors may have read too much into encouraging European data from the first few months of the year, which is always highly vulnerable to seasonal distortions, The continent is  showing signs of a massive manufacturing inventory overhang, especially in autos. If this is correct, then European growth may be set for a tumble in the second quarter. Slovakia may be a perfect canary in the coal mine: the country has the highest percentage of export-dependent GDP in the OECD and is the manufacturing base to a slew of car companies like Volkswagen, PSA, Kia and JLR. Slovakia’s industrial confidence tumbled in April to the lowest since November 2012. Meanwhile, European stocks are at a level that that over the past twenty plus years has marked the top, MI2 says. The risk-reward on shorting European stocks now looks compelling.

Trade talks still in a likely stalemate

To get some sense of what investors see playing out from the latest developments on the trade talks Cornerstone Macro conducted a poll of their clients yesterday, with the question: ”What do you think’s priced in?” A) No deal, talks continue, tariffs don’t increase to 25% from 10% on $ 200 billion. B) No deal, talks continue, tariffs move to 25% on $ 200 billion. C) Come to an agreement and rollback tariffs. The results showed an almost 50/50 split between A and B, with just 4% of respondents saying C. Cornerstone held a conference call on trade talks yesterday where they argued that it will be difficult for a deal to be reached that allows both sides to save face. They think the most likely outcome is the tariffs will go into effect on Friday and the Trump will spin the communication to make it sound like progress is being made, but in reality progress is not very likely. Markets are currently more optimistic it seems, but risks have definitely increased.

A better time for a trade war

For equity investors, there is a never a good time to have a trade war. Nevertheless, if there must be one, the US stock market is now better placed to ride out a US-China tariff conflict than it was a year ago, writes Tan Kai Xian from Gavekal. Yes, an escalation of the trade war will hurt, says Gavekal, but that’s not so much because of the direct impact of tariffs on earnings. Rather it is because an increase in tariffs is likely to lead to an offsetting rise in the US dollar, which will erode the value of USA Inc’s overseas earnings, and because increased uncertainty will weigh on corporate investment and in turn on earnings growth. However, given that analysts’ earnings forecasts are already low—and undershooting—the market is less likely to experience a deep downward rerating of earnings expectations as tariff increases take effect. Furthermore, expect US equities to be more resilient than in 2018 is that inflation expectations have subsided, which means the Fed has some leeway to support the market with easier monetary policy should the uncertainty engendered by the fear of higher tariffs begin to bite.


15 minutes of fame for the equity derivatives desk

During every market correction, equity derivative desks at sell-side banks have 15 minutes of fame, writes Neil Azous from Rareview Macro. The last time they were recognized was the first week of October. While it is too early to tell if they will gain the same notoriety this week, their war-cry is loud, he says. That’s for the reasons outlined in the Nomura piece, also included in today’s briefing. Rareview Macro concurs with their points and key levels, but adds that they do not think there are enough longs who want to take down that much risk, only to find out there is a deal and are forced to buy that position back 2-3% higher. And this is where the equity derivatives desk comes in. Rareview highlight a range of trades – on the assumption that the SPX 2880-2865 level holds – that investors might look to construct. These include buying downside equity index put option strategies that expire next week that capture a spillover following confirmation of increased tariff, An expansion into other assets, such as the DAX, as its very exposed to auto tariffs is US-China goes native, and long gold, short US equity volatility trades just in case this was all a negotiating tactic, and not to leave out the fixed income derivatives team, buying US fixed income upside convexity. Rareview say US fixed income is highly correlated to the VIX, and although there is a call skew, it is much cheaper than buying short-term SPX puts or VIX calls.


Tracking CTA and systematic fund flows

Nomura’s quant team track systematic trend-following players such as CTAs and also risk parity funds on a daily basis. They observe that the market has taken on an increasingly event-driven flavor as market participants, having lost some of their interest in corporate earnings and the health of the US economy, attempt to pin down how America and China will proceed. Nomura believes CTAs have been forced to begin liquidating long positions built up since the end of March, as the S&P 500 is now sitting below what they believe to be the first trigger point for selling at roughly 2,915. They expect systematic selling to ease if the S&P 500 manages to hold the line above 2,820, which they think is the next trigger point. A drop below this level may well encourage further unwinding of long positions. On risk parity, Nomura say these funds have begun reducing their exposure to stocks in response to the jump in volatility. As of now, this is mainly a matter of bringing leverage ratios down, but the effect of this may well rear its head in the futures and options markets. Of course, if volatility were to become persistently high, risk-parity funds would presumably set themselves to portfolio rebalancing that in turn could have a knock-on effect on cash equities, Nomura adds. Time to pay careful attention to the behavior of CTAs and risk-parity funds.

The bigger story behind Trump’s trade tweets

Trump’s entire trade agenda is grinding to a halt and he needs a breakthrough on China to get it moving again, writes James Lucier from Capital Alpha, the Washington DC policy research firm. Bringing together intel from the DC sources and public announcements made from US officials and beyond, Lucier has done a great job at explaining why the a China trade deal is so essential to all of the moving parts that represent the broader US trade strategy. A China deal is the catalyst from everything else. This includes USCMA, and an important deal with Japan. Furthermore, the latest threats also ups the stakes for tariffs on European trade. As for the tweets, Lucier says that for those who think Trump is impulsive in everything he does: this is mostly true.  But he says that staffers who are willing to work with the boss’s impulses instead of stifling them can make Trump’s tactical tweeting into a strategic asset, which maybe the case in this situation. It seems very likely that negotiators communicated the deal-or-no-deal message privately to their Chinese counterparts, in advance of the President’s tweets so that they would not be caught completely off-guard by the President’s actions and would have a considered response available for it. If you’d like to read the full note, click below.

Ni Hao, Volatility

There hasn’t been this much attention on a US – China airplane ride since Nixon went to Beijing, writes Nick Colas from DataTrek. News that the latest round of trade talks will still happen made the headlines, but to his thinking it was long rates and Fed Funds Futures that lifted US equities from their retail investor-induced opening lows in yesterday’s equity trading. He expects that dynamic to hold this week, dampening volatility. But it does put the Fed into an ever-tighter box the longer it continues. That’s because what we saw in yesterday’s trading was one more affirmation that US equity valuations are tied at the hip with market sentiment on interest rates and Federal Reserve policy. This seemed to get lost in the narrative of when the Chinese trade representatives will fly into Washington this week, says Colas. The Fed Funds Futures are now back to giving better than 50-50 odds of a rate cut in 2019. With US equity volatility looking to rise this week, markets will inevitably back into an ever-stronger view that Fed policy will have to shift. On the plus side, that should limit daily slides in stock prices. On the downside, it paints the Fed into an ever-tighter corner, says Colas.

Trading Trump’s trade gambit

Just as a combination of benign intermediate and long-term sentiment readings and positive price and fundamental momentum was lining up for the bulls, Trump tweeted out a tariff threat on Sunday to raise tariffs on the Chinese. But as Cam Hui, from the Pennock Idea Hub sets out in this piece, while initial price action will be a key test of market psychology, he shows that the combination of benign intermediate and long-term sentiment readings, and positive price and fundamental momentum, remains bullish for equities. Notwithstanding Trump’s threat to impose further tariffs on China, Hui’s base case scenario calls for US equities to continue its steady advance after a brief hiccup.

EZ leading indicator: Germany is bottoming, but not rebounding

SouthBay Research focuses delivering actionable data and insight on labor and capital goods markets, the core elements of business and economic activity. As such, their analysis acts as an effective leading indicator and they’ve built up a formidable track record. Indeed, they consistently rank in the top 3 forecasters in the US labor markets. In Europe, they’ve made some prescient calls on the economic downturn, as early as last summer their indicators were forecasting a sharp downturn, well ahead of most sell side forecasters.  So what do they see now? SouthBay reckon a bottoming out process is underway, but it is gradual. A rebound is still far away as the contraction continues, but at a slower rate. SouthBay say this is contingent on China, and the recent bounce there will help, but structural problems dominate the slowdown. The slowdown in global trade is no help for Germany, and domestic consumption remains tepid.