“Market sentiment is fragile”, JPMorgan’s Marko Kolanovic writes, in a note dated Wednesday.
Amid the trade frictions and mounting uncertainty, discretionary investors have trimmed their exposure to stocks, with hedge funds’ net exposure now in just the 5th percentile. Gross exposure, Kolanovic writes, is elevated, reflecting longs in defensives and shorts in cyclicals and value, as dictated by the macro backdrop.
Overall, Kolanovic maintains a constructive outlook, as he has since the beginning of the year, when he called for quick return to all-time highs, a prediction that played out in short order. That said, he describes his stance as “cautiously positive”. That professed caution is, of course, the product of an inability to predict what the Trump administration might do next.
“Given the recent erratic behavior of the US administration [a positive outlook] carries risk”, Marko writes, before explaining that despite political entropy, “we think that low investor positioning and an unprecedented divergence between defensive and value market segments warrant exposure to trade-sensitive and high-beta segments, which are now largely pricing in a recession.”
Kolanovic doesn’t mince words when it comes to the deleterious effect the trade war has had on sentiment and markets more generally. He explicitly says that US trade policy has had the effect of negating the boost from the initial fiscal stimulus push. Here is the passage from Marko’s Wednesday note which will doubtlessly grab headlines in the financial media:
The past 2 years of equity market history can be roughly divided into 2 phases: a rising market in anticipation of fiscal reform (that boosted the economy and corporate earnings), and a value-destroying trade war. The trade war has so far offset all benefits of fiscal stimulus and, if continued, may lead to global recession. If this recession materializes, historians might call it the ‘Trump recession’ given that it would be largely caused by the trade war initiative.
Some have suggested that Trump is engaged in a strategy that involves risking a recession in order to prompt the Fed to cut rates, after which time he will call off the trade wars and hope that a combination of relief and easier Fed policy will mean a recession is averted and stocks surge to record highs.
In addition to being a highly risky “plan”, it is by no means clear there is in fact a “method” to Trump’s “madness”. Speculation that the president is “crazy like a fox”, is just that – speculation.
As Marko goes on to note, it makes little sense to suggest that somehow, the tariffs have made the US “richer”. He divides things into two phases, the first being the tax cut phase and the second being the “trade wars are good and easy to win” phase (a reference to Trump’s infamous tweet). Here is a visual:
(JPMorgan)
Kolanovic’s assessment is straightforward – indeed, it borders on blunt, which is appropriate under the circumstances considering how unequivocally precarious US trade policy has become.
Referencing the chart above, Marko notes that unless there’s meaningful progress on the trade front soon, the US manufacturing gauge could sink into contraction territory.
He goes on to describe a similar dynamic in equities. “The estimated cost of the trade war so far is about ~$3T [and] this may be a conservative estimate as many market segments benefited from flight to safety and declining yields”, Kolanovic writes, alluding to the possibility that were it not for the rally in certain safe havens, the broader market might have traded even lower.
Next, he drives the point home. To wit:.
The market damage is ~100 times the tariffs collected, so it is clearly not making the country richer. The impact of the trade war was particularly negative on segments that were its intended beneficiaries — such as manufacturing (autos, electrical equipment, etc.), smaller domestic companies, steel industry, etc.
That, folks, is the cold, hard reality of the trade war, and that’s to say nothing of the impact it’s had on US farmers, who have now been forced to accept not one, but two government bailouts.
So, what’s the good news? Or, put differently, why is Kolanovic still cautiously positive?
Well, because this can all be undone. For Marko, it’s not too late for the situation to be fixed and given the political ramifications of a “Trump recession” and a precipitous market decline ahead or (or during) an election year, the odds of a resolution are relatively high.
“Given all of this — why are we not bearish on equities and the economy? Because this situation can also be undone on short notice and many market segments already price in worst-case outcomes”, Kolanovic says, citing the decision to back off the Mexico tariffs as an example.
While some may point to Trump’s penchant for acting irrationally as a reason not to assume an outcome reflective of clear thinking, it’s worth remembering that if there’s anything the US president does care about, it’s his ego, and losing in 2020 would be a grievous blow in that regard, even if some part of Trump would rather not be president in the first place.
“As a strong market and avoiding a recession would boost re-election odds, it would only be rational to expect this outcome”, Marko says.
Of course, there are alternative methods for preventing further escalations. Lawmakers could, for instance, try to take the keys away. As Kolanovic puts it, “there are other ways to neutralize the risk such as Congress taking back control of tariff powers, etc.”
Yes, “etc.”
XLK has TTM P/S of 4.2 and P/B of 6.7, with record amounts of corporate debt outstanding, and that’s pricing the worst-case scenario? Jesus, I’d hate to see what his idea of optimistically priced valuations are. I know, he’s a titan of finance and I’m nobody, but everyone makes mistakes. I just don’t get why everyone assumes the ride up is 100% deserved while downward movements are largely irrational. It’s usually the other way around.
where do you see XLK mentioned in here? it’s not. i don’t want to be too hard on readers, but you can’t just conjure an ETF, cite some stats for that ETF and then implicitly claim that an analyst recommended it. that’s the very definition of a straw man argument. these are sparse quotes from one note from a quant. if you want JPMorgan’s official house view on Tech, you would need to consult the latest sector-by-sector breakdown from the bank’s equity strategists.
“We think that low investor positioning and an unprecedented divergence between defensive and value market segments warrant exposure to trade-sensitive and high-beta segments, which are now largely pricing in a recession.”
I’m challenging the idea that high-beta segments are pricing in recession, and XLK was just a quick proxy to do that. You’re right; he doesn’t say tech specifically. However, I imagine my point will hold regardless of what high-beta etf or fund you might want to examine. The point is, equities are pretty expensive by many measures, and saying that cyclicals are largely pricing in recession just because defensives have outperformed recently seems a bit of a stretch to me. Cyclicals have outperformed for years, all equities have arguably outperformed “fair” returns for years, and a couple of months of relative underperformance hardly means the worst-case scenario is priced in.
that’s a better answer. 🙂 thanks for fleshing out
Great observation and extrapolation, Chris; imo, spot-on in sentiment;. I agree and could not have put it quite so succinctly and wonk-free(~ish) accessible. Thanks.
“Well, because this can all be undone. For Marko, it’s not too late for the situation to be fixed and given the political ramifications of a “Trump recession” and a precipitous market decline ahead or (or during) an election year, the odds of a resolution are relatively high.”
Ah, yes, once again the argument that something won’t happen, because if it did, it would be bad.
I believe they said the same thing about Brexit. And about war in 1914.
Brexit and World War II would be much harder to undo. The point is that it literally only takes one man to change his mind and all this can be undone
Yep, that’s why they said World War I wouldn’t happen, too.
I think the puppet master is doing cartwheels in the Kremlin. His puppet just gave some new jet fighters to Poland. The best the US has. Might as well just have given the Russians one.
Trump may not “want” to be president but losing presidential immunity and control of levers on justice may be fraught with peril.
Intelligent people might have stupid world views and ideas. This one is a good example. A quant calibrated on a decade of buy-the-dip QE orgy.
The trade war is not happening for the last 2 years. It is an artifact of the past 40 years after the western world gave China a chance to play along. China abused this opportunity. Shit needs to be undone.
I’m not sure you understand what the job of analysts is. It’s not to opine on the relative merits of one world view versus another one. it’s to help clients make money
and, no, “shit” doesn’t need to be undone. what needs to be undone is this lunatic effort on the part of the Trump administration to roll back 70 years of globalization and trade openness which has helped pull millions upon millions of people in emerging economies out of abject poverty. sorry, not sorry, about Joe midwest’s factory job
Have some sympathy, guy. Joe midwest has kids to feed. Us not caring about him is why Trump got elected – they know we don’t give a shit about them. Thanks Hillary.
that’s not the point. the point is that, from a utilitarian perspective, globalization is unequivocally good. Trump’s narrative implicitly (actually, explicitly) suggests that Joe’s job at the factory and Joe’s family are more important than someone’s job and someone’s family in an emerging market economy, even if globalization has literally meant the difference in people starving and not starving in some EMs. If Joe has to learn a new skill or take a job making $36,000 instead of the $75,000 his dad made at the factory so that people can eat and have clean water in EMs, well then so be it. the world has changed. rolling back globalization won’t work. Trump is finding that out.
Am kind of glad you said that H……It is easy to get that point out of context when reading volumes of stuff..thanks…
Marko forgot to mention the negative effect of the tariff is also 100 times. There is always a price to pay in a war. The question is now “Do you want to win the trade war?”.