Trade war is dangerous, but market responses a little overdone

Outlook:

The trade war with China is taking a toll specific to companies that sell into China, names like Boeing, Caterpillar, and Gillette. The Daily Shot has a big series of charts from sources all over the place showing the trade war effect in just the first few hours. The Bloomberg "consensus forward P/E ratio for the S&P 500 dipped below 17x again. When will the analysts begin revising their forecasts down in response to the trade-policy headwinds?"

Other sectors are soft for their own reasons (tech, pharma), but the mining sector is down as commodi-ties, especially metals, are all down fairly dramatically (hence the AUD's performance). Elsewhere in commodities, lean hog futures hit the dirt (the US exports a lot of pork to China).

One of the most shocking of the Daily Shot charts is the response of crude oil futures to the Bolton ap-pointment—the price shot up. This is because Bolton favored the Iraq war and dislikes the Iran treaty, and is expected, literally, to want to start another war in the Middle East. And Bolton has no problem attacking N. Korea first.

The Bolton appointment is more than a little strange—Trump railed against "stupid wars" that gained the US nothing and cost a lot, and then hired a well-known war-mongerer. Bolton is smart—smarter than Trump—and like most neocons, is actually quite hard to rebut because his arguments are tightly reasoned. Finding the flawed assumptions and false "facts" is very difficult. Those who debate Netan-yahu have the same issue. Luckily for us, Bolton is rude, crude and intemperate, just like Trump. Un-less Bolton is willing to back down to keep his job, conflicts are sure to erupt. We give him less than year... unless he manages to start a war before then.

While all this looks terribly dangerous, market responses are probably a little overdone. We've only just begun the trade war with China and you can bet the White House thinks it's already "winning." The US imposes $60 billion in tariffs and the come-back from China is a piddly $3 billion. As time goes by, we guess China will negotiate lower tariffs on its stuff and will stick with the $3 billion, if on-ly to win in the court of public opinion. As for China getting mad and withdrawing from the Treasuries market—no. China doesn't get mad. China gets even. Trump says the US has been screwed by decades of bad trade deals. But China was screwed by the West for centuries. Think Opium Wars.

This is not to say the trade war is not going to be the real deal. It will be, and as numerous economists have pointed out, it's not just the obvious losses we can expect, it's also the unintended consequences that arise from both pass-through effects and pinball effects. Breakfast at the diner will be cheaper as bacon prices go down. That's a silly example but valid all the same. Meanwhile, the folks who will likely get hit the hardest are the very folks that voted for Trump. We have no idea whether this means Trump is sticking to principles or he just doesn't care about the little guy. So far, the trade war is wel-comed by his voters.

To get back to the somewhat more real world, recall that traders make decisions and take positions based on expectations of economic and institutional outcomes. Earlier this year we justified the euro's rise on the grounds that the US rate hike was old news while expectations for a faster-growing econo-my and accelerated end of QE in the eurozone was fresh news. This makes sense. It also made sense to downplay Draghi's exhortation not to over-expect. What else should he say?

But now the eurozone is starting to fumble and stumble a little. The PMI's yesterday were discourag-ing. The ZEW and IFO surveys are retreating a little. Expectations for acceleration are being dashed. Citibank's surprise index was designed specifically to measure the divergence between expected and actual, and used to project a currency forecast on that divergence. We invented something similar at Citibank many years ago, but the surprise index is far better. See the chart. But keep in mind that on the whole, it's a short-term thing. All it takes is one or two unexpected data points to turn it around.

In the meanwhile, while we think the dollar "should" be weak on Trump's near-certain mismanagement of the trade war (plus Bolton), it's actually the euro that will be weak for authentic economic reasons. This is not quite the same as soft vs. hard sentiment, at least as practitioners apply those terms, but close.

 

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