BofA’s Blanch: ‘Traditional Models May Soon Be Obsolete And The World Unforecastable’

It’s likely that markets (to the extent we’re talking about carbon-based lifeforms and not just headline-scanning algos) reacted positively on Monday to Donald Trump’s story about a phone call with top Chinese officials not because anyone necessarily believed it, but rather, because the US president’s willingness to fabricate a dialogue suggested his pain threshold on stocks has been reached.

If that’s the case (i.e., if the “Trump put” has kicked in after a fourth straight week of losses for the S&P), then it may presage actual, real dialogue between Bob Lighthizer and Liu He, who on Monday garnered praise from Trump for comments he made overnight.

Of course, this could all change in the blink of an eye, but as of the opening bell on Wall Street, the assumption appears to be that Trump is sufficiently worried about the market to avoid chancing another escalation.

Read more: Trump Says ‘China Called Last Night’. China Says ‘Hasn’t Heard Of Such A Thing’

But irrespective of the day-to-day headline hockey, analysts and economists worry that there’s no turning back, and that, increasingly, both sides are prepared to resort to self-harm and irrationality.

In a great note out Monday, BofA’s Francisco Blanch (who, incidentally, made a cameo on Bloomberg TV this morning), embarks on a review of where we are, how we got here and where we’re likely headed, assuming nobody swerves in this perilous game of chicken.

“For those still wondering what is being discussed inside the White House, Peter Navarro’s works are an instructive read”, Blanch writes, reminding you that “Navarro… believes that global free trade is an academic fantasy, that the current economic system is biased against the average American [and] that the only major economy in the world that has truly practiced free trade for decades is the US”.

Blanch notes that the latter point is probably at least somewhat accurate. Average US tariffs have been ~1% for years upon years, until Trump’s ascension to the Oval Office.

(BofA)

That, BofA writes, is a “historical anomaly” given that “global hegemons in prior centuries did not practice free trade, mostly because it was not in their interest”.

America’s commitment to free trade was born out of a desire to use soft power in the wake of WWII to triumph in the Cold War. BofA here defines soft power as “a combination of open markets, democracy and human rights”.

In short, the strategy appears to have failed vis-à-vis China, which BofA notes “took advantage of America’s global trade framework to expand its share of the world economy in dramatic fashion and soon became the world’s largest manufactured goods’ exporter, quickly beating America at its own economic game”.

The bank concedes the obvious, which is that corporate America has benefited handsomely from trade with China (hence the persistent blowback from US executives to the trade war), but BofA says that if you ask them, “the average US voter has not benefitted [and] America’s industrial and manufacturing base has shrunk, creating a national security problem”.

Navarro would agree, and so would Trump, although the president’s views on this are the product of decades worth of attention-seeking behavior, rather than academic rigor. That is, Trump arguably never cared about this unless elaborating on the subject publicly afforded him an opportunity to garner some publicity, and he only cares about it now because the populist agenda that got him elected centered on rewriting the rules of global trade and commerce, a promise that played well with the disaffected voters BofA references. Trump’s brand is tacky, opportunistic jingoism, not economic nationalism.

Getting back to BofA, Blanch goes on to note that there are almost no historical parallels to the current scenario which finds the world’s two economic powerhouses embroiled in an all-out trade war.

“The Anglo-Dutch trade disputes of the 17th century are perhaps the closest historical parallel”, the bank says, adding that “neither the Smoot-Hawley Tariff Act of 1930 nor the Opium Wars in the 1839-60 period are particularly good illustrations of what is going on today on a macro basis”.

(BofA)

For Blanch, the US does, in fact, have the upper hand. In addition to the obvious fact that China cannot retaliate commensurately using tariffs due to the goods trade disparity, BofA reminds you that “while setting tariffs on manufactured goods can enhance the welfare of a large open economy, most tariffs on raw materials likely result in a net welfare loss for the importer because of their high price elasticity of supply”.

The implication is that when China slaps tariffs on things like oil and soybeans, it is demonstrating a propensity for self-harm, which in itself is an ominous sign.

Zooming in on the oil tariff announced Friday, Blanch writes that it will “hurt domestic Chinese refining margins, reduce the competitiveness of Chinese petroleum product exports, and disadvantage the Chinese energy industry ahead of the 2020 IMO high sulphur bunker fuel phase-out deadline”.

More colloquially, the new oil duty is an even more dramatic instance of cutting one’s nose off to spite one’s face than the soybean tariffs which were (and are) an effort to hit Trump where it hurts politically (i.e., by turning the famers against him).

Again, that’s disconcerting. As Blanch puts it, “the latest round of tariffs suggests that China’s pain threshold is higher and its time horizon longer than the market has assumed so far”.

Frankly, that should not be a surprise. After all, China has indicated time and again over the past year that it can and will play the longest of long games with Trump (and any successors) if that’s what’s necessary. In an interview from Brussels in May, Zhang Ming, China’s envoy to the EU, reminded the world that China “has been holding on for 5,000 years”. “Why not another 5,000 years?”, he wondered.

The implications for markets are clear – or, actually, the opposite of clear, depending on how you want to couch things.

Blanch argues that the mechanical impact of tariffs on domestic prices notwithstanding, tariffs are “highly deflationary”. This is just the demand destruction argument, and you’re seeing it play out in commodities. The ultimate impact could be quite dramatic, BofA warns.

“If tariff changes affect inflation as they have historically, inflation could collapse to levels not seen in decades”, Blanch writes, adding that “a tariff is a tax, and a tax is a form of fiscal tightening [and] because of that, global rates should continue to head lower as long as the tit-for-tat tariff war keeps escalating”.

(BofA)

Against this backdrop, policy uncertainty should continue to rise, dragging measures of market volatility and recession odds along for the ride.

In the post-crisis era, central banks have managed to preserve the disconnect between market-based measures of volatility and policy uncertainty with credible forward guidance around policy rates, asset purchases and other forms of monetary accommodation. Whether that’s tenable going forward is debatable given how little “ammo” central banks have left. Forward guidance on rates and QE can lose credibility to the extent market participants 1) don’t think those tools worked in the first place, and 2) believe those tools are exhausted.

Blanch suggests that all of this will likely mean “investors will continue to rotate into gold and US Treasuries to shield themselves from the escalating trade war, and away from cyclical assets including commodities”.

Strategists from Goldman and Deutsche both wrote late last week that 10-year US yields could drop to near record lows in the wake of the trade escalations, and the case for gold essentially makes itself right now. 10-year yields are on track for their largest monthly drop since 2015 in August.

Yields fell to 1.4695% just after the Asia open on Monday as markets reacted to Friday afternoon’s tariff escalations and weekend headlines.

Blanch’s broader conclusions, though, are more disconcerting than any prediction about safe-haven flows.

“Traditional econometric models used in forecasting economies and markets could soon become obsolete”, he writes. “World economic growth could become unforecastable”.

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