A Two-Front War, Tariff Headline Hockey And The Updated ‘SG Swan Chart’

Donald Trump spent the better part of H2 2018 complaining that Jerome Powell’s Fed wasn’t giving him the dovish cover he needed to wage his trade war.

During his infamous July interview with CNBC’s Joe Kernen, Trump made it abundantly clear that he understood the extent to which a “trade” war is really just a “currency” war. The Fed, by leaning persistently hawkish, was contributing to dollar strength by driving the monetary policy divergence between the US and the rest of the world wider. The irony, of course, was that the reason the Fed had to lean so hawkish in the first place was precisely because Trump’s fiscal stimulus and trade policies were ostensibly inflationary. Not only that, the tax cuts were USD+ for a variety of reasons (e.g., repatriation, making USD assets more attractive by juicing the domestic economy and equities) and the trade war itself put pressure on non-US assets, making the case for investing in the US stronger still. It was, as we were keen to point out, an “insanity loop.”

In late September, Trump finally pushed the trade envelope too far by moving ahead with tariffs on $200 billion in Chinese goods and then, just days later, Jerome Powell effectively doubled down on the hawkishness with his “long way from neutral” boondoggle. The die was thus cast and the rest is market history.

Both Powell and Trump attempted to rescue the market on November 28 and December 1, respectively, with the Fed chair walking back his October communications debacle and the President striking a tentative truce with Xi in Argentina. At that point, though, is was too late. The market had already suffered a grievous blow and the narrative had turned bearish. Trump’s efforts to pressure Powell into leaning overtly dovish at the December Fed meeting backfired in spectacular fashion. We now know (based on the December minutes) that the Fed had actually already relented, but Powell failed to communicate that properly in the post-meeting presser, likely because he felt the need to reinforce the central bank’s independence in the face of the President’s tweets. Just a day later, Trump decided to force what has since morphed into the longest government shutdown in US history.

Finally, on January 4, Powell gave Trump the dovish cover the White House has been after since last summer. In the days that followed, a procession of Fed speakers reinforced the message. The dollar fell and stocks soared.

Trump being Trump, he’s now figured out a way to jeopardize that cover. Had he simply signed the bipartisan bill that was ready to go last month, he would likely now be in a position to stick to his guns vis-à-vis Beijing, holding out for a complete surrender by the March deadline beyond which the tariff rate on the $200 billion in goods taxed at 10% from September 24 will more than double to 25%.

But now, thanks to the protracted shutdown, investors are wary of the nascent rally and it feels like we’re one tape bomb away from seeing things turn south again. True, we’re also one positive catalyst away from a melt-up that would see systematic strats re-risk, forcing in the fundamental/discretionary crowd, but the shutdown, if it goes on much longer without just such a positive catalyst hitting the tape, has the potential to effectively negate the Fed’s efforts to shore up sentiment.

And so, you end up with the administration in a panic to get a trade deal done in order to stay out ahead of a situation where the market sells off again and the Fed is forced to try and jawbone things higher, only without a clear way to do so barring a relent on the balance sheet plan.

Witness Thursday afternoon’s Wall Street Journal “scoop” that suggested administration officials are “debating ratcheting back tariffs on Chinese imports as a way to calm markets and give Beijing an incentive to make deeper concessions in a trade battle that has rattled global economies.”

Remember when the “incentive” for Beijing to make deep concession was the threat of more tariffs? Now Trump officials are apparently adopting the exact opposite strategy, and the reason is clear: there’s a growing sense that the reprieve granted markets by the Fed will prove short-lived unless there’s progress on trade.

It’s certainly not lost on the administration that the shutdown is starting to bite. Kevin Hassett said as much earlier this week. Similarly, Hassett has acknowledged (with a smile on his face) that Apple’s “shock” guidance cut is likely to be the first of many similarly dour outlooks if the trade dispute drags on.

Treasury was of course quick to deny the Journal’s reporting, but the denial wasn’t really a “denial.” “Neither Mnuchin nor Lighthizer has made any recommendations with respect to tariffs or other parts of the negotiations with China”, a Treasury spokesperson said. Of course the Journal didn’t really say anybody made a “recommendation” – they just said it was something that’s come up. And you know it probably has given Mnuchin’s palpable disdain for Trump’s aggressive trade policies.

Hilariously, the market’s reaction to the headline might well increase the chances that this non-recommendation gains traction with Trump. The move was faded so quickly (when the denial hit) that it was barely worth mentioning, but this is the kind of “vertical acceleration” that President “How’s Your 401(k) Doing” would really love to see more of going forward.

(Bloomberg)

The bottom line here (in case it’s not clear enough from the above), is that Trump has predictably boxed himself in. If he wants the fledgling stock surge to be some semblance of sustainable, he needs to either end the shutdown, strike a trade deal or, preferably, both.

The problem is that doing either of those things risks making him look weak. Don’t forget, the whole reason the government is shut in the first place is because Trump didn’t like the coverage he got on Fox News last month when it looked like he was prepared to sign the bipartisan bill to keep the government funded. Last May, Mnuchin struck a trade truce with Vice Premier Liu He only to see Trump immediately renege after Steve Bannon weighed in (which was absurd, considering Bannon was by that point nine months removed from having any official capacity in the administration) and the protectionist contingent threw a fit. Do you see a pattern?

With all of that in mind, note that SocGen is out with the latest update on their “Swan Chart” and sure enough, “the risk of a further intensification of the multi-front trade war with the US at its centre [is] still the biggest downside risk facing global growth.”

(SocGen)

The bank does note that the risk of a trade war is “fading”, but the assumption remains that things will get worse before they get better.

“We doubt that an agreement can be made in time for the 1 March deadline that would avoid the hike in tariffs on US imports coming from China from 10% to 25%, and China would be bound to reciprocate”, the bank writes, before delivering the “good” news which is as follows:

However, we still regard the risk of an all-out trade war as only an outside risk, even between the US and China, and expect agreements that would allow tariffs to be disbanded in the second half of the year. Moreover, we have downgraded the risk of the trade war/protectionism from 25% in September to 20% now. Official commentary around the US-China negotiations has become much more positive recently. Moreover, after the agreements between the US and Mexico and then Canada concluding in September, the survival of NAFTA — albeit under another name — has been achieved (assuming it is ratified by all sides). In short, if anything, we’d put a downward bias on the 20% probability. It is also worth noting that irrespective of the course of US trade policy, most of the rest of the world is continuing to march towards more free trade agreements. The most impressive example is the official start of the son-of-TPP (also referred to as TPP11) on 1 January 2019, which involves very significant reductions in tariffs between its 11 participants.

That’s all fine and good, but it doesn’t speak to the threat of auto tariffs and it also doesn’t say much about global stability when banks have to start saying things like “irrespective of the course of US policy”.

SocGen goes on to note the obvious, which is that the second biggest downside threat to global growth in the chart (“China hard landing”) is inextricably bound up with the first.

The bank’s (highly subjective) probability of a hard landing in China was not reduced in this latest “swans” update despite the modestly reduced probability of an all-out trade war materializing. That’s in part because it’s not just trade that’s weighing on the Chinese economy. “Aside from collateral damage on China’s economy from the trade tensions, the risk of which appears to be easing, there have been other worrying signs, such as unexpected weakness in Chinese retail sales and in car sales”, SocGen writes, before warning that “a sudden loss of confidence among Chinese households would have serious implications for not just the Chinese, but the world economy — hence, an unchanged risk of a China hard landing.”

That feedback loop – between the Chinese economy and the rest of the world – was on full display earlier this month when Apple slashed its outlook.

So where does this all leave us? Well, it leaves us in a situation where Trump is going to have to pick his battles. He can’t fight a two-front war with the Democrats and China if the former entails keeping the government shut much longer. There’s not enough dovish Fed cover in the world for that. It’s inconceivable that the Fed would be able to do anything to rescue sentiment if, in his clearly unstable mental state, Trump decides to let the shutdown persist indefinitely and allows the March deadline with China to pass with no resolution that forestalls the hike to the tariff rate.