While many had considered that Trump’s ever more bitter trade war tirades and rhetoric were just that, at best a negotiating tool as nobody could conceive the US president actively pursuing measures that could potentially threaten the US economy and stock market, over the past month it has dawned on most that in this case, Trump is not bluffing.
In fact, as Morgan Stanley’s chief US public policy strategist writes in the firm’s Sunday Start note, “we no longer doubt that the US administration’s proposals signal the direction of trade policy. An escalatory cycle of protectionist actions, not just rhetoric, has begun and will continue.”
In addressing Trump’s unexpectedly stark retaliations, observed in the presidents engagement with China, the EU and Nafta nations, Zezas also notes that “this pattern of behavior shouldn’t be ignored: the US and its key economic partners now view trade differently. One party’s in-kind response is the other’s escalation. This is what a vicious cycle looks like.“
This, an increasingly bearish Morgan Stanley writes, is yet “another reason why pressure should continue in risk markets” and lists four specifics reasons for its negative outlooks:
- The duration of these conflicts should now be measured in quarters, not weeks
- Markets will discount multiple steps.
- It doesn’t have to be a material economic problem to be a market negative.
- When it comes to policy, markets had their dessert before their vegetables
Expecting further fallout from trade wars, Morgan Stanley now sees many ways to position for escalation, predicting that tech will be the sector most affected by the emerging “vicious cycle” writing that in stocks, “tech is vulnerable as a sector where pricing has been insensitive to trade risks so far.” Separately, Morgan Stanley also sees Asia EM entering a bear market, with the Hang Seng particularly vulnerable.
As for US rates and fixed income, the bank picks “duration over credit”, writing that trade risk is one reason why “the 10-year Treasury has seen its high in yields – a positive for duration-sensitive asset classes like munis – while US credit should underperform further on late-cycle concerns.”
The bank’s last reco is to go long VIX as another spike in volatility is not too far off:
our cross-asset team sees value in being long volatility across a variety of asset classes into the summer.
As one potential offset to his bearish outlook, Zezas offers that the he may be underestimating the resolve of Congressional Republican leaders, who generally support free trade, to take back some tariff power from the White House through legislation, although as he concedes, polls suggest division within the party on this issue.
Which is why the Morgan Stanley strategist concludes that the only true “circuit breaker” to Trump’s escalating trade war resolve would have to come from the “scoreboard” – namely a drop in the markets coupled with a jump in volatility.
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His full note below:
Trade Risk: Believe the Hype
by Michael Zezas, Chief US Public Policy & Municipal Strategist at Morgan Stanley
We no longer doubt that the US administration’s proposals signal the direction of trade policy. An escalatory cycle of protectionist actions, not just rhetoric, has begun and will continue. It’s another reason why pressure should continue in risk markets, which now must eat their US policy vegetables after feasting on dessert in 2017.
Our ‘dessert before vegetables’ thesis suggests markets were conditioned for unambiguously accommodative policy outcomes entering 2018. A major, tax-driven fiscal stimulus had been just inked by an administration fond of pointing to the stock market as a scoreboard. Trade policy followed another scoreboard, bilateral deficits, making it possible for markets to envision a path away from the fundamental uncertainties of escalation and toward negotiation. A reduction in the US-China trade deficit could keep tariffs and other measures at bay, de-escalating the conflict without putting the global growth dynamic at risk. Treasury Secretary Steven Mnuchin appeared to signal this outcome on May 20, stating that “We’re putting the trade war on hold” following China’s announcement that it intended to increase purchases of US commodities.
What happened next, though, showed that US rhetoric did not seek to extract quick concessions, but rather to articulate a deeper disagreement. US officials announced their intention to go forward with tariffs on US$50 billion of goods. China outlined steps in response, and the US countered by proposing tariffs on another US$200 billion of goods. Meanwhile, the US broadened its scope, allowing tariffs on steel and aluminum imports from the EU, Mexico, and Canada to take effect. When these countries responded, the US began to prepare auto tariffs. This pattern of behavior shouldn’t be ignored: the US and its key economic partners now view trade differently. One party’s in-kind response is the other’s escalation. This is what a vicious cycle looks like.
Given present market conditions, we think this dynamic exerts pressure on risk assets.
- The duration of these conflicts should now be measured in quarters, not weeks. Benign, negotiated outcomes may still be the endgame, but an extended cycle of escalation will give fundamental impacts time to play out in company financial statements and economic data.
- Markets will discount multiple steps. We now must focus on the cumulative and interacting impacts of the next few rounds. Hence we’ve argued that investors should expect both the auto tariffs and the second round of China tariffs to go forward.
- It doesn’t have to be a material economic problem to be a market negative. Some have been quick to point out that announced actions fall far short of Smoot-Hawley trade barriers and anti-growth impacts. We agree. But that doesn’t mean they’re not negative for markets or couldn’t get worse. Consider guidance from corporations like Daimler, MillerCoors, and Brown-Forman regarding the profit and demand impacts on their products from tariffs. Trade conflicts can create headwinds to earnings, and hence valuations, without sparking a recession. Hard-to-define downsides from further escalation only heighten uncertainty. Hence…
- When it comes to policy, markets had their dessert before their vegetables. Entering 2018, we think that markets were pricing in the positives of the US policy agenda, assuming that tax cuts and increased spending would add to GDP (Morgan Stanley estimate +0.5pp) while shrugging off trade risks as hypothetical. Today, the more complicated realities of the US agenda have come into sharper focus and risk offsetting the positives. Thus, even apparently minor trade actions could be market negatives.
We see many ways to position for escalation. In equities, our team thinks that US tech is vulnerable as a sector where pricing has been insensitive to trade risks so far. We also see Asia EM entering a bear market, with the Hang Seng particularly vulnerable. In US fixed income, we like duration over credit. Trade risk is one reason why we think the 10-year Treasury has seen its high in yields – a positive for duration-sensitive asset classes like munis – while US credit should underperform further on late-cycle concerns. Finally, our cross-asset team sees value in being long volatility across a variety of asset classes into the summer.
Of course, we must consider where we could be wrong. We may be underestimating the resolve of Congressional Republican leaders, who generally support free trade, to take back some tariff power from the White House through legislation, although polls suggest division within the party on this issue. Hence, a near-term ‘circuit breaker’ to trade escalation is more likely to come from the scoreboard – namely, more challenged and volatile markets.
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