“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:
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.”