Thoughts on Trade Policy

Second Quarter Results

As we conclude the first half of 2018, the trading and investment climate has been challenging. Volatility has ramped up this year and trade war rhetoric has only exacerbated the issue.

Our portfolio is up 11.1% for 2018, YTD compared to 3.5% for the S&P 500. Towards the latter part of June, we decided to start raising cash in the portfolio given deteriorating market internals and an unfavorable technical picture. As we closed the quarter, cash and cash equivalents was 56% of the total portfolio. This brought out total portfolio beta to just 0.36 as we await a better entry point to start building positions.

The arbitrage portfolio had an exceptional quarter, largely driven by the successful AT&T / Time Warner merge-arb opportunity. The outcome of that specific opportunity altered our sector allocation from last quarter with the addition of AT&T from the merge-arb discount. AT&T is currently our largest holding representing approximately 15% of the portfolio and making the Utilities sector our greatest industry exposure. The current breakdown marks the Utilities sector as 42% of the non-cash invested portfolio value, Cyclicals is 17%, Energy at 13% and Health Care near 12%.

We are comfortable holding a larger position in AT&T and believe the “utility-like” performance of the company will provide us with stability and dividends during a time that we are not entirely bullish on the overall market. We also believe the addition of Time Warner content offers earnings growth at a reasonable price.

Given the recent market turmoil surrounding trade disputes, we thought it would be appropriate to share our thoughts on the current policy actions.

Trade Policy

It shouldn’t come as a surprise that President Trump has thrust trade policy to the forefront entering his second year in office. On the campaign trail leading up to the general election, Mr. Trump bombastically targeted our global trading partners and ridiculed previous U.S. leaders for entering “unfair” and “disastrous” trade deals.

While one can discount the rhetoric as showmanship, performing for a frustrated voter-base, there certainly exists a bit of apprehension on the part of equity market participants as to the precise actions this new administration will take. Global trade is a dynamic topic that needs to be examined and executed in a deliberate manner that requires more than 140 (now 280) characters. Admittedly, we do not have material knowledge and insight into the inner mechanics of those formulating policy but taking President Trumps soundbites as a general precursor of what lies ahead it would appear his arguments are rather one-dimensional for such a complex issue.

This is especially true when taking into account the sheer size of China related trade. According to a working paper by Lawrence J. Lau of Lau Chor Tak Institute of Global Economics and Finance, The Chinese University of Hong Kong entitled A Better Alternative to a Trade War, “We begin by examining the size of the 2017 U.S.-China trade deficit. The U.S.-China trade deficit in goods, according to official U.S. data, was US$375 billion, compared to official Chinese data of US$276 billion. There are many reasons for the large discrepancy between the official data of the two countries. After adjustments for the differences in the valuation of exports (f.a.s. (free alongside ship) in the U.S. versus f.o.b. (free on board) in China) and imports (customs basis in the U.S. versus c.i.f. (cost, insurance and freight) in China) and in the treatment of re-exports through Hong Kong, the discrepancy can be reduced to between US$325 billion (Chinese data) and US$368 billion (U.S. data). If trade in services, in which the U.S. has a surplus of US$38 billion in 2017 according to U.S. data, is included, the 2017 U.S.-China trade deficit can be estimated to be between US$286 billion and US$330 billion. It is not clear why there is such a large remaining discrepancy in the official data on trade between the two countries. However, an annual discrepancy of approximately US$40 billion has persisted since 2004. It cannot be explained by the difference in the timing of the departure of goods from one country and arrival in the other. One possible source of this discrepancy is re-exports to the U.S. of Chinese exports via ports other than Hong Kong. Another possible source of discrepancy is a systematic valuation difference between “customs basis” by the U.S. Customs and “f.o.b.” as reported by Chinese exporters, reflecting perhaps the under-invoicing of Chinese exports by Chinese exporters in order to reduce profits booked in China and hence Chinese taxes.”

Drain the Swamp

The most blatant criticism that we reserve is the double-standard regarding policy direction that was expressed during the campaign. Being a “non-politician”, President Trump appears to pride himself as a Washington outsider that is there to “drain the swamp” in order to put America first.

Tackling deficiencies in our trade policy head-on is certainly admirable, but bending to special interest groups, as seems to be the case in the most recent round of tariffs on steel and aluminum goes against everything we have come to expect from President Trump as a disruptor. Damning the many to benefit the few is not how Mr. Trump fashioned his presidential campaign but is masked under the MAGA brand.

Simon Lester, a trade policy analyst with Cato’s Herbert A. Stiefel Center for Trade Policy Studies summed it up nicely when he wrote, “Also caught in the crosshairs will be U.S. industries. Many U.S. producers, such as car makers, which accounted for 26% of demand for steel in the U.S. in 2017, use these products as inputs in their finished products, and when tariffs are imposed and lead to increased prices, their competitiveness suffers. It may be that the biggest impact from these tariffs is to put U.S. producers at a disadvantage in comparison to their foreign competitors, which means job losses here in the U.S. (jobs in U.S. industries that use steel or inputs made of steel outnumber jobs in steel production by roughly 80 to 1).”

With 25% tariffs on $50 billion of Chinese goods, this has prompted the Chinese policy makers to retaliate in-kind. According to a study commissioned by the Consumer Technology Association and the National Retail Federation, the immediate impact from the 25% on $50 billion of goods will cost the U.S. approximately 134,000 jobs. According to a recent report by the Peterson Institute, tariff contagion that spreads to Japan, Mexico, Canada and South Korea will could eliminate up to 624,000 U.S. jobs in the near-term aftermath of such policy action.

A report by the U.S. Chamber of Commerce states the withdrawal of NAFTA on the part of the U.S. will shed some 1.8 million jobs.

Not exactly the optimal growth trajectory for an economy that is entering it’s potential final stages of expansion.

Trade as a Zero-Sum Event

Another grievance that we tend to agonize over is the false narrative that trade is a zero-sum game, with a winner and a loser. This tends to resonate with President Trumps most adherent supporters but is very much a one-dimensional way of viewing how we interact with our global trading partners. Many Presidents before Mr. Trump have promoted protectionist values as red meat, but few have actually gone on in their presidency to successfully implement protectionist policies to the benefit of our country. In fact, protectionist trade policies have somewhat of a sordid history on a global level. In the U.S., there is a close relationship between the passage of the Smoot-Hawley Act and the Great Depression. Smoot-Hawley was a protectionist bill that was implemented by President Hoover in the late 1920’s, early 1930’s that attempted to protect the U.S. from predatory trade practices through the use of tariffs. If you follow the timeline of events, it is clear today that the passage of the act was not in the best interest of our country. On May 28, 1929 the House passed the Smoot-Hawley Act. On October 28, 1929 the Senate urged President Hoover to sign the bill and he agreed. On the very next day, October 29, 1929 the stock market crashed. According to History.com, “On October 29, 1929, Black Tuesday hit Wall Street as investors traded some 16 million shares on the New York Stock Exchange in a single day. Billions of dollars were lost, wiping out thousands of investors. In the aftermath of Black Tuesday, America and the rest of the industrialized world spiraled downward into the Great Depression (1929-39), the deepest and longest-lasting economic downturn in the history of the Western industrialized world up to that time.”

In March of 1930, despite a letter from over 1000 economist warnings on the pitfalls of a trade war, the Senate passed the bill and it became law in June 1930. GDP declined by 8.5% in 1930, 6.4% in 1931 and 12.9% in 1932.

The policy was a failure and prompted President Roosevelt to sign the Reciprocal Tariff Act on June 12, 1934, thereby reversing the devastation of the Smoot-Hawley Act. The U.S. economy started growing again with GDP up 10.8% in 1934, 8.9% in 1935 and 12.9% in 1936.

The stock market as measured by the S&P 500 followed suit, declining 85% from September 1929 through July 1932. Upon the reversal of policy and the resumption of economic growth the market rallied back 308% over the next few years.

As Winston Churchill once said, “Those who fail to learn from history are doomed to repeat it”. On May 3, 2018 President Trump received a letter signed by 1,140 economists warning of the pitfalls of a trade war.

There are several other examples on the failures of protectionist trade policies. In an article from the U.S. Chamber of Commerce they write, “In fact, there is a historical record that conjures parallels to the isolationist brand of trade policy the U.S. is pursuing. It was known as Import Substitution Industrialization (ISI), and it was such a resounding failure that it died an unseemly death in the 1970s.

While ISI was pursued in multiple Latin American countries in the decades following World War II, Chile was its poster child. Seeking a way to shield its nascent manufacturing sector from global competition, Chilean policymakers implemented protectionist measures in the form of high tariffs and duties, strict quotas, exchange controls, and restrictive import licenses in an active effort to discourage goods importation.

In theory, the aim was to rely almost entirely on domestic consumption to fuel development of a Chilean manufacturing sector unburdened by the presence of foreign competition. In practice, what transpired was an economic disaster that traced its roots to gross inefficiencies, wanton misallocation of capital, and systemic market distortions. Chile’s economy entered into a self-reinforcing death spiral whereby inefficient production begot higher costs, rampant inflation, soaring unemployment, and stratospheric levels of national debt. At ISI’s nadir in 1972, inflation spiked past 200%, the fiscal deficit topped 13% of GDP, public debt mushroomed by 300%, hard currency reserves evaporated, and real wages declined by 25%.”

Similar to our experience with trade policy missteps, this tale has a positive ending as policy makers realized the error of flawed policy.

“Fortunately for Chile, we know how the story ends. In the eighties, Chilean policymakers cast off the burden of ISI to pursue market-oriented reforms that eliminated protectionist trade barriers and encouraged foreign investment. A Chilean export sector that was virtually non-existent in the era of ISI now accounts for one-third of the country’s GDP”.

Trade has traditionally been viewed as a symbiotic benefit between two partners - a “win/win” narrative. Thus, if we view our aggregate economic output as a function of real personal consumption, plus real gross investment, plus real government consumption, plus the difference between real exports and real imports, we find an intricate collaboration of moving parts that drive the economy. A desultory approach towards economic policy that doesn’t consider all the cumulative variables may fail to have its desired outcome.

Deficits and Trade

Our current fiscal path is one of higher deficits and increasing national debt. One could argue that the most logical fiscal policy actions that could be taken to improve our aggregate trade deficit is one of austerity. But given President Trump’s current trajectory of fiscally stimulative measures in a late stage economic growth cycle, it is clear that balancing the budget is far removed from current thinking, even though it would tackle a seemingly important policy issue such as the trade deficit.

Randall W. Forsyth of Barron’s wrote, “One of the less obvious, but more ironic, aspects of Trump’s ire about trade deficits is how his policies directly increase the gap between exports and imports. Moreover, by increasing the demand for foreign capital to fund that deficit, the U.S. is dependent upon foreign countries in a way the president abhors when it comes to metals. The so-called twin deficits are born from the same zygote, as JPMorgan economists Michael Feroli and Daniel Silver explain. When the U.S. invests more than it saves, it must borrow from the rest of the world. (A government deficit represents negative savings by the public sector.) That’s because the nation spends more than it earns when it imports more than it exports.”

To continue to fund our deficit we need to sell Treasury securities. The Federal Reserve has taken a hawkish stance on monetary policy and the US Treasury can no longer rely on quantitative easing measures to soak up excess borrowing needs, so the US will need to rely on other sources of liquidity. Currently China is the largest foreign holder of US Treasury securities with $1.18 trillion or approximately 19% of foreign holdings.

John Maudlin of Mauldin Economics writes, “You hear a lot about China’s owning so much of our government debt. It’s true, but to some degree they have little choice. So long as the US runs a trade deficit with China and we insist on paying for our imports with dollars, China will probably continue to use those dollars to buy dollar assets with that export revenue. It can happen indirectly: Maybe China buys raw materials from Australia with the dollars, and then the Australians buy dollar assets. But in any case, the amounts are so vast that the Chinese gravitate toward the most liquid dollar asset –Treasury bonds.”

Without embracing the entire economic process, solely targeting our trade deficit with China will amount to nothing more than a cosmetic campaign promise while doing little to reduce our global aggregate trade deficit.

Rouge Presidency

When it comes to international diplomacy, President Trump goes out of his way to relay the message that he isn’t taking any guff. Whether it be backing out of the Paris Agreement on climate change or the Trans-Pacific Partnership, American Exceptionalism, at least through the eyes of the Trump Administration will not be compromised. Even his breaking of protocol to accept a congratulatory telephone call from Taiwanese President Tsai Ing-wen, a clear violation of current “one-China” policy by Chinese officials indicates President Trump beats to his own drum.

He also has the moxie to withdraw, or at least threaten to withdraw from existing agreements such as NAFTA and the Iran Nuclear Deal. Some will find this attribute admirable, some will find it disturbing. Regardless of what side of the isle one identifies with, there needs to be a respect of current rules and laws in place for the global system to function properly.

It is abundantly clear during the campaign of then-candidate Trump’s displeasure with China when it came to trade and currency manipulation. It is equally perspicuous that his Administration is using methods to implement his agenda that defy traditional rules of engagement.

In order to justify the implementation of the steel and aluminum tariffs, President Trump, through his Secretary of Commerce Wilbur Ross, invoked Section 232 of the Trade Expansion Act of 1962 allowing broadly defined trade actions on the part of the executive branch in the name of national security. This action emerges as a blatant attempt to usurp the spirit of the law in order to punch a political ticket. It comes across as additionally disingenuous when the man delivering the message, Mr. Ross, made his fortunes by acquiring bankrupt US steel companies for the ultimate sale to a foreign nation in a previous life. It is our belief that this type of strong-arm tactics will do little to influence both the Chinese and the World Trade Organization as they surely don’t want to emerge from this in a weakened state. It could also establish a dangerous precedent as other nations attempt to retaliate under the same auspices of national security.

Daniel Ikenson in the Cayman Financial Review wrote, “These measures are much more problematic because the flimsiness of the national security rational is reinforced by the president’s numerous on-the-record statements that the restrictions were needed to respond to unfair trade practices (for which there are other remedies) and not exceptional “security threats.”

Moreover, the manner in which Trump is wielding the tariffs as bargaining chips exposes a certain frivolity to the national security claim. It appears that Trump was seeking the leverage that comes with having the authority to impose sweeping tariffs, and invoking Section 232 of the Trade Expansion Act of 1962, was an easy way to get it.

Because that statute gives the president broad discretion to define what constitutes a national security threat and even broader discretion to design a remedy to mitigate that threat, he has the latitude to modify the tariffs or exempt countries from its reach. Trump exempted Canada and Mexico on the condition that the renegotiation of the North American Free Trade Agreement proceeds to his liking. Meanwhile, Trump is dangling before the Europeans and others promises of exemptions in exchange for their purchasing more U.S. exports, selling fewer wares to Americans, or ramping up their NATO spending.”

Without going through the proper channels established within the WTO, the US runs the risk of eroding the common order of things to keep the trade machine rolling. In a paper by Robert Krol from Mercatus Research Center at George Mason University entitled Does Uncertainty over Economic Policy Harm Trade, Foreign Investment, and Prosperity? He writes, “One way to reduce uncertainty about international economic policies is to form international associations and agreements. The WTO requires a member country to commit not to raise tariffs above a certain level set by the organization. In return, the other members of the WTO agree to keep their tariffs at or below the same binding levels. WTO membership imposes policy discipline and a set of rules to resolve international policy disagreements. Those rules serve as a device to commit to a policy of lower trade restrictions. They are binding commitments about the future course of trade policy. These commitments should promote more credible international economic policies, which would lower economic policy uncertainty and lead to greater trade and prosperity.”

This is a key ingredient in the volatility we have seen of late within the global equity market, in our opinion.

Preparing our Portfolio

We wanted to analyze the pricing action of various equity markets within times of extreme economic policy uncertainly in an effort to glean how markets tend to react. To measure economic uncertainty, we used the Economic Policy Uncertainty Index created by Scott R. Baker, Nick Bloom and Steven J. Davis.

What we found was an inverse relationship between the Uncertainty Index and the global stock markets. When used as a contrarian indicator, it appears the markets tend to form a bottoming process when economic uncertainty is at its highest extreme levels.

The following chart shows the Economic Policy Uncertainty Index expressed as a Z-Score. We highlighted the one standard deviation level and decided to track equity returns of various markets one year prior and one-year preceding periods of high economic uncertainty.

We used several US based indexes and sectors as well as those of our major trading partners. As excepted, one can see upward spikes leading into the Asian currency crisis and Russian bond default in the 1990’s, September 11, 2001, the Great Recession of 2008, the European debt crisis of 2011 and the election of President Trump in 2016.

What we found is significant market underperformance in the twelve months leading in to a period of economic uncertainty. Adjusting for alpha and volatility we found the markets that suffered the greatest drawdowns were China, Japan, Taiwan and the Eurozone. In the US, the sectors with significant performance erosion were financials and technology.

While this is useful insight, unless one has a crystal ball that can foresee economic turbulence, it is not very practical or actionable. What is interesting from an investment standpoint are the twelve month returns in the wake of a one standard deviation move to the upside. Across all the markets that we analyzed we observed across the board market outperformance relative to historic norms. This certainly has played out in the US in the aftermath of the Trump election within domestic markets.

The countries with the greatest alpha, adjusting for volatility have been Japan, China, Taiwan and India. The sectors with the greatest performance have been Financials and Technology.

The notion of unfettered trade between nations is beneficial for both the importer and the exporter. In Mr. Krol’s research he notes, “In 1992, the sum of exports and imports as a percentage of GDP was 19.5 percent. By 2016 that figure had increased to 26.4 percent. The increase is attributed to several factors, including reductions in trade barriers, global economic growth, and technological change. Gary Hufbauer and Zhiyao Lu estimate that the expansion in trade has increased US GDP per person by $7,014 (2016 dollars) since the end of World War II. International investment has expanded along with the growth in trade. The real level of foreign direct investment into the United States reached $11.8 billion by the end of 1992. By 2016, it totaled $67.5 billion. Foreign investment increases labor productivity, wages, and national income.”

In our opinion, President Trump has a bigger bark than bite and his unorthodox approach to this sensitive situation will most likely fall under the “negotiating tactic” heading. Corporate earnings continue to rise and the US and global economies appear to be in solid shape. Global yield curves remain positive. We track the global yield curves of all the major countries (developed and emerging) and find that 100% of the countries in our index have a normal upward sloping curve as measured by their respective sovereign two-year and ten-year rates.

We further breakdown regional yield spreads as a percent of each countries GDP contribution to their respective fields. All the regions (developed and emerging) have upward sloping but flattening spreads.

Given the recent spike in the Economic Policy Uncertainty Index above one standard deviation due partially by the US-China trade conflict, we are not altering our market outlook and continue to believe the path of least resistance, at least as it related to the US equity market is higher.

Joseph S. Kalinowski, CFA