Markets today awoke to the news that the one proponent of free trade on Trump’s team had resigned. And that Trump wanted his team to work at breakneck speed on the paperwork to implement the imposition of tariffs. Whoa.
Markets reacted probably as expected equities sold, and bonds rallied. Bonds rallied because equities sold. The reverse correlation works again.
However, for markets trying to understand what the implementation of tariffs means all is largely illusory. There is no detail and we are all in the dark with a huge headache. What to do? The economists are telling us that the likes of China won’t sell bonds because it hurts them. But to say so is meaningless as they clearly don’t understand China.
For Trump, the evidence of the reason to impose tariffs is clearly there for all to see. The trade gap has widened to 5% and is the worst since 2008 and the fifth straight month of a rising deficit and the highest in nine years.
Of course, there is a reason to impose tariffs. How much worse does it need to get? The only problem is that Trump is also attacking his allies on a trade front when the U.S. clearly needs some assistance.
Now lets a step back and take that Bex. (Bex is an aspirin delivered by a paper for those that don’t know).
China can play the game to its advantage. It now has a President for life, so political stability is there. China imports mostly commodities and intermediate products such as soya meal, aircraft and computer chips (3% of the market for the U.S.). Any tariffs imposed are largely meaningless.
Hence, China can choose not to react. It can meanwhile watch inflation in the U.S. spike because the U.S. imports mostly consumer goods. These pass through relatively fewer hands and are more vulnerable to price increases that quickly pass through to the consumer.
China can play a waiting game and watch the U.S. hurt itself.We know that over the last few years the investment in U.S. treasuries by both China and Japan has been steadily decreasing. China holds about $3.1 tr of reserves of which about $1.2 tr is invested in treasuries.
At the peak, Japan owned about 25% in 2004 and China owned 20% in 2009. Those holdings have now fallen with China owning 9.4% and Japan owning 8.4%. If China or Japan thought inflation was to rise then the simple answer is to sell treasuries because their holdings are at risk.
Both may also sell to teach a lesson whilst playing victim.A significant move at, say, an average of $500 a basis point per million would round up a significant loss should bond yields rise 1% which a scenario easily hit should Trump impose tariffs and the consumer in the U.S. pays more for those goods.
In fact, the PMs at the People Bank or the BOJ would be derelict in their duties if they failed to protect their portfolios. For China though, this is an important lesson they can teach the U.S whilst remaining the victim of unfair trade laws imposed on their country. This is a game not easily won.
For some of the Fed hawks, such as Lael Brainard, they see the headwinds now turning to tailwinds and are keen to raise rates, fearing inflation rising as economic growth rolls in from the tax cuts (perhaps). If Lael is correct, then the Fed will be raising rates, the carry trade will become more uneconomic and as such the yen could strengthen and bonds yields should slowly rise.
And that’s also causing a headache for bond investors. Markets will become increasingly choppy and the outlook for equity valuations may start to stall as multipliers give way to valuations.
We saw evidence of that today as Exxon did something daring by announcing a capex plan rather than a share buyback and was sorely punished. The equity market wants to gorge on share buybacks and dividends it has no time for projects that may be risky and require capex. Exxon are trying to make America great by doing things a well-run company should do such as explore for new fields in the Permian Basin and increase chemical plant expansions except its share price fell 3.1%.
And on a day when wages growth for December 2017 was reported as seeing a 2.0% rise and 2.5% annually, productivity stalled falling 0.1%. This should be of concern to both equity investors and debt investors as inflation can rise rapidly under this scenario if momentum continues.
The headache though for the market is how to react to Trump imposing tariffs and the impact that will create. The markets will need a lot of Bex because if imposed, tariffs will become a major headache for companies, how they invest, rising costs and finding new sources and suppliers.
Investors will have the problem then of picking winners, who will survive and hedging their bets for the inevitable increase in inflation.
The appetite for risk may be changing and this will no doubt cause more headaches.
Take a Bex you will need one.
Equities: The S&P 500 fell 0.06%. The Dow fell 0.35% after falling at one point 1%. The Stoxx 600 rose 0.4%. The Vix closed at 17.57.
Currencies: The Bloomberg Dollar Spot Index was steady. The euro was steady.
Bonds: The ten-year closed around at 2.88%. The 2-year closed at 2.25% and the 30-year closed at 3.15%. The ten-year bund closed at 0.67 and the UK gilt closed at 1.50% and the OAT closed at 0.904%. The U.S. curve closed 2/10 at 62.9 bp, 2/30 at 90 bp and the 10/30, closed at 26.5 bp. The U.S. 5-year closed at 2.65.
Commodities: The WTI fell 2.3 %. Gold fell 0.23%.
Bitcoin is trading around $9,818.9.
Aussie Market Today.
Equity markets should remain choppy as there is not a lot of positive news out there. Given offshore sold, there is probably the case for selling equities.
Bonds could be somewhat sluggish. However, given the likely imposition of tariffs, bond yields are more likely to rise in the U.S. rather than rally and especially if the bond market catches a whiff of inflation.
For Australia, this probably is not such a big problem. However, any significant rise in bond yields in the U.S. should see bonds rise here. Now may be a time to think floating rate assets.