Market volatility increased dramatically during the first quarter, driven largely by three factors. First, the world’s major central banks are moving toward tighter monetary policies. Higher interest rates and waning liquidity are significant global macroeconomic risks, especially given that many assets have recently traded toward the high end of their historical valuation ranges.
Second, technology has become a dominant macro factor for capital markets across all sectors. Moreover, the technology sector itself has been a major driver of market performance; fears of increased regulation on the sector served to rattle the markets. Finally, the looming possibility of trade wars weighed on markets in the first quarter.
We believe this policy transition constitutes the most significant global macro risk, and it’s especially worrisome given the imbalances and valuation excesses that currently exist. It’s especially difficult to reconcile the unwinding of unparalleled central bank balance sheet sizes at a time of record peacetime government debt and multi-century record low yields. Prior to the Lehman Brothers bankruptcy in 2008, this trifecta would have been all but unimaginable.
Trade wars on the horizon?
We have written for years on the global benefits of trade. Trade wars are lose-lose outcomes. Let's step back 200 years. In 1817, David Ricardo, an economist, displayed the rationale for global trade. At the heart of his theory of comparative advantage is the recognition that even if one country has an absolute advantage in producing every good in the economy, it’s unlikely to have the same relative production advantage in every product. To illustrate, imagine two countries, A and B, and a world that desires two goods in equal amounts: food and clothing. Country A is a more mature country with a higher overall standard of living; Country A also possesses labor productivity that’s greater than B for each good under production. Country A takes one day to make one unit of food and two days to make one unit of clothing. Country B, on the other hand, is much less productive in each instance, taking three days to produce a unit of food and four days to produce a unit of clothing. The table below illustrates the production output of each country after 100 days if they don’t trade with each other.
Country A will spend 33 1/3 days on food and 66 2/3 days on clothing to have 33 units of each. Country B can only produce a total of 14 units each in the same time period because it spends 42 days making 14 units of food and just under 58 days on 14 units of clothing. Under this scenario, the two countries together produce 94 units of the two items with Country A contributing 70% of the total.
Trade can fuel enhanced productivity—and wealth
The key to understanding the benefit of trade is to envision A and B as one combined country rather than two separate entities. We can reconfigure the days available for production in a far more efficient manner. The table below shows a scenario in which Country B focuses solely on producing clothing and spends no days producing food while Company A spends 50 days producing food and the other 50 days producing clothing. The result is 100 units of food and clothing for the combined countries—6.4% more than in the first scenario.
The way the surplus of six units is apportioned will depend upon the bargaining power and capabilities of the two countries. Since the first table shows that Country A is just over twice as productive as Country B (66 units ÷ 28 units), a reasonable split might be 4 units to A and 2 units to B. Here, it’s important to note that both countries have won. Country A now has 70 units (as opposed to 66 from the first table) and Country B has 30 units (as opposed to 28). This is the theory of comparative advantage in action. It’s powerful, it’s good for all participating nations, and it shows that the process of free trade can make every country a winner.
The limits of free trade
Within a nation, almost everyone benefits from the effect of trade. The key word here is “almost.” There are industries and workers that become dislodged by globalization. To rectify that cost requires better policies, including training and income supplements. Since each nation has a “plus” in its GDP from trade effects, a portion of that “plus” should be used to help those individuals who have been harmed by the effects of trade. Western countries, and the United States in particular, have been poor at addressing the side effects of globalization. In our view, President Trump was elected based largely on his promise to address these side effects, albeit perhaps at the expense of globalization itself. The president stoked the fear of trade wars to come by announcing tariffs on $50 billion of goods from China, along with making threats about abandoning the North American Free Trade Agreement and comments about leaving the World Trade Organization.1
This isn’t to say that there aren’t real issues with America’s trading partners that need to be dealt with; regarding China, market access, intellectual property protection, and forced partnerships require serious and detailed negotiations. Further, the Chinese government’s China 2025 plan increases Beijing’s involvement in the economy through various explicit and implicit subsidies. As a result, disputes with China are here to stay and will remain prominent in newspaper headlines.
Some people—President Trump and his economic advisors among them—claim that America’s trade deficit stems from bad free trade deals and countries such as China not playing by the rules. However, Paul Krugman and many other economists believe that America’s low savings rate is a much more important factor. The lack of savings means the United States needs to import capital to fund investment and, as an accounting identity, this capital account surplus implies an offsetting current account deficit. This is particularly relevant now because the U.S. personal savings rate—defined as the percentage of personal disposable income that is saved rather than spent or invested—has fallen sharply from over 6.0% in late-2015 to just over 3.0% today. (For context, the post-1960 average is 8.2%.) The only time the savings rate was lower was during the housing bubble prior to the global financial crisis of 2008.2
A worsening fiscal imbalance, a widening trade deficit
To those economists that agree with the savings rate argument, the possibility of a trade war is particularly worrisome given that overall U.S. savings rate is bound to fall even further, driven by increased government dissaving. The budget deficit, which was already large, will become even larger following the Tax Cuts and Jobs Act of December 2017. According to government data, the U.S. federal budget deficit is projected to almost double from its 2014–2016 average of 2.8% of GDP and may very well approach 6.0% in 2019.3 This would constitute the worst budget deficit ever, excluding periods of war and recession. The fiscal binge would mean even more borrowing from abroad, and a further widening of the overall current account deficit. This would come against a backdrop of a U.S. trade deficit that has recently approached historically large levels. The trade deficit averaged $42 billion per month in 2016, but has since reached $56 billion—quickly approaching the record $66 billion deficit of August 2006, toward the end of the housing bubble.4
If President Trump really starts a trade war, that event—combined with the enormous amount of debt required to finance the deficit resulting from the tax cut and additional fiscal spending passed by Congress—suggests potential trouble could lie ahead in late 2019. We expect that volatility would rise substantially and higher interest rates would negatively impact valuations for both stocks and bonds. In the distance, we can see a storm brewing.
1 U.S. announces tariffs on $50 billion of China imports, Wall Street Journal, 4/3/18.
2 U.S. Federal Reserve Bank of St. Louis, April 2018.
3 Congressional Budget Office, April 2018.
4 U.S. trade deficit races to more than nine-year high, Reuters, 3/7/18.