Goldman Presents: 3 Reasons For Equity Investors To Fear A Slowdown In Global Trade

So obviously, deglobalization is a terrible idea.

It’s a step backward in time.

It represents the devolution of society into tribalism, nationalism, xenophobia, etc.

In short: it’s dumb. As in literally dumb. It’s evidence that we are, as a global community, actually getting stupider in terms of our ability to identify as human beings first and Americans, Russians, French, Chinese, etc. second.

Which helps to explain why the people who support deglobalization seem to be unhinged, stupid, or in some cases both.

Part of the anti-globalist agenda pursued by the Trump administration involves choking off global trade. Not to put too fine a point on it, but that’s even dumber than deglobalization more generally.

That is, if your anti-globalist, anti-progressive stance stems from a desire to protect against a perceived threat from “outsiders” (e.g. “the terrorists”) and that desire finds expression in the closure of borders and the adoption of an “us versus them” (or at least “us first”) mentality, well then I guess you can kinda, sorta justify it.

But if your anti-globalist agenda stems from some fantasy you harbor about returning the domestic economy to a bygone era when global supply chains weren’t as integrated as they are now and when capital and labor didn’t move freely across borders, then you are quite simply delusional.

Which is the real tragedy of Trump’s trade policies. He’s not going to bring back American manufacturing. It’s not possible to usher in the “renaissance” he’s promised to facilitate. It’s simply not going to happen and he damn well knows it. Which means two things: 1) he’s lying to some members of his support base, and 2) he’s going to end up erecting barriers to global trade growth for no discernible benefit.

Of course that may be a little too 30,000-foot-ish for some readers, so here’s Goldman to explain what the possible knock-on effects are for US equities of slower trade…

Via Goldman

Given the current relatively benign backdrop for investors, it is always worth thinking about what could go wrong and derail the economic cycle — and with it the equity cycle. We see three reasons why dislocations in trade could affect equity markets:

1. Valuations are high (albeit still comfortable relative to bond markets).
2. Margins are very high (particularly in the US).
3. Volatility is low. With regard to high valuations, while they are cushioned to some extent by bond markets (equity risk premia remain elevated), as Exhibit 4 shows, this is partly because bond yields continue to be very well anchored. Much of this support could evaporate if bond yields were to rise to a significant extent.

Meanwhile, equity valuations relative to history are elevated in most markets (Japan is a notable exception). Since most equity markets would not be immune in the event of a meaningful drawdown in the S&P Composite Index, it is relevant that the US equity market in particular is close to the highs of its 40-year history on most metrics, particularly for the median company.

While high valuations are not typically the cause of a bear market, they can impact the size of a drawdown if it occurs. And while current high valuations are largely justified by a strong and benign fundamental macro environment, they could magnify a trading correction into something more serious if tensions on trade were to cause a reassessment of the stability of the environment.

Similar to valuations, margins are highest in the US equity market. While this is a sign of strength, particularly in the technology sector (which alone has been responsible for roughly 60% of the rise in US margins since the previous trough in 2009), it leaves room for disappointment (see Exhibit 6). Slowing world trade can increase prices and reduce revenue. Higher labour costs are also a risk for the US as unemployment continues to fall.

Moreover, it is worth noting that high margins are not just a function of US technology companies or defensive industries. As Exhibit 7 shows, even in the case of Europe (where domestic growth has been challenged over recent years) margins in the most cyclical industries (excluding commodity producers) are at an all-time high. These again would be vulnerable to a deterioration in world trade.

Low volatility is not in itself a problem but rather a reflection of the current optimism about the global environment. As Exhibit 8 shows, vol spikes can occur around major political events and economic downturns. The current lack of liquidity in some markets could also exacerbate any shift in volatility regime even if the actual economic impact of any trade tariffs is relatively small.

The risks to equity investors via the growth channel

From an equity market perspective, the risks of any ‘trade war’ relate not so much to the absolute impact of such measures on the global economy, but rather the impact on uncertainty and sentiment. This particularly so at a time when valuations are already very high and volatility is very low, and the impact that any increase in trade tariffs could have on the rate of change in global growth.

This is important because, despite the improvement that we have seen in the level and breadth of global growth over the past year, the rate of change is fading. As Exhibit 9 shows, there is a fairly close relationship between the global PMI and the year-over-year change in global equity markets; moreover, despite the strong June US PMI, the pace of macro surprises since earlier this year has also weakened. It is also worth remembering that, for equity investors, it is not only the level of growth that is important but also the rate of change. The pace of earnings revisions (a strong tailwind for equity markets over the past year) is starting to fade (see Exhibit 9).

Looking at a typical economic cycle (in this case for the US equity market), the pace and level of growth are both important. The strongest phase of returns is typically not when growth is strong but when it is weak and the rate of change stops deteriorating. This is consistent with what we describe as the ‘Hope’ phase of the typical cycle. The period of growth when it is both above-trend and accelerating typically generates the second-highest returns, but also the lowest volatility. The ‘Slowdown’ phase as growth rates moderate is normally associated with lower returns (still positive) but with higher volatility. Of course, the lowest returns are in the phase of deteriorating and slowing activity. This suggests that any weakness — or indeed risk of weakness — in global growth as a result of trade wars could result in faster-slowing global growth and, alongside this, weaker returns in equity markets.