Three months ago, in the aftermath of the February VIXplosion and when the shape of Trump's protectionist agenda was only just starting to take shape, JPM's head quant, Marko Kolanovic made a simple prediction: despite all his posturing, Trump would never dare to pursue an aggressive trade war that destabilizes markets for one simple reason - if stocks crash, it would make a Democratic victory more likely in the midterms, which in turn raises the threat of Trump getting impeached.
The JPM quant also laid out the various possible outcomes between trade war and Fed policy error in terms of a game theoretical "prisoners' dilemma" matrix, as follows:
A significant trade war started by this administration would destabilize global equity markets. Should this happen ahead of the November election, it would impair the administration’s ‘market scorecard’ and likely lead to an election loss. Lost elections open a path to impeachment, and other complications. The game is also non-zero sum, as one can both use tough rhetoric and at the same time do little disruptive action (e.g., players as we defined them can ‘have their cake and eat it’). Setting up a diagram (similar to the well-known ‘prisoners’ dilemma’) points clearly that there will be strong rhetoric, but weak or no action that would destabilize equities.
One could argue that a similar analysis can be applied to the risk of the Fed committing policy errors (see figure below, asymmetry in the case of the Fed would be causing a recession, and the public pinning the blame to specific individual central bankers responsible for the decision).
Needless to say, back then Kolanovic was especially bullish, as he has been for much of the past year. And, for those who follow his musing, his bullishness has persisted until now - largely as a result of his views on investor positioning, which the quant believes is not bullish enough ever since the February flush which saw an outsized liquidation by many marginal market players - and which in light of the market action appears to have been accurate.
Fast forward to today when Kolanovic is out with a new note, in which he takes another look at the impact of Trump's trade wars, now that they have had a chance to develop and mature, and his latest assessment appears far less optimistic than it was before, to wit:
In 2016, we argued that the probability of Trump winning the presidency was higher than the consensus and that it would likely be positive for equities. This double out-of-consensus view materialized as the new administration enacted pro-market policies such as tax reform. However, since this March, the impact of trade and protectionist policies became a significant market headwind. It is a broad consensus across academia, business leaders and market practitioners that trade wars and protectionism are a lose-lose economic proposition.
But most notable is that Kolanovic's original skepticism that Trump would never dare to roil the markets tremors appears to have faded, if not evaporated, and has been replaced with a big question mark, as not even Kolanovic can pretend he knows what Trump may say or do next. His epiphany is below:
Earlier in March we argued that the current administration cannot afford a disruptive trade war that would destabilize equity markets in an election year. While we still think this is true, trade tensions continue to inflict damage to investor psychology and business confidence. A negotiation strategy that includes bluffing/threats can be successful in a two-party negotiation setup, but is more likely to deliver self-defeating results in a complex system such as global trade (e.g., think of supply chain disruptions, the uncertainty it introduces in long-term planning, etc.).
More interesting is what Kolanovic does next, which is to put the cost-benefit or rather cost-cost analysis of Trump's growing protectionist agenda in the context of the market moves over the past three months, or as he puts it, "we have attempted to quantify how the market value was impacted by trade war policies since March." He explains how, and what the number is below:
By attributing the trade-related news flow (positive or negative) to the performance of the US market, we estimated the impact on US equities to be negative 4.5% (with a margin of error of +/-1%, Figure 1). Taking the current market capitalization, this translates into $1.25T of value destruction for US companies.
The number is notable because it is well over half, or nearly 2/3 of the value of Trump's entire fiscal stimulus which has so far been the crowning achievement of the Trump administration. What is perplexing to Kolanovic is why Trump would threaten to undo the fiscal stimulus by pursuing a populist agenda which has, in his view, little benefit to either the economy or to markets.
But more to the point, after being convinced that Trump would never engage in the kind of bi- and multilateral trade feuds as he has, the JPM strategist now concedes that Trump's trade wars could in fact have an adverse impact on markets, especially if the trade wars persist.
The value destroyed by a trade war might be reversible if policies are reversed, while the positive impact of fiscal measures is likely to remain. This would likely catalyze a ~4% market rally. However, if this uncertainty hangs over the market for a more extended period of time, the damage becomes more permanent and the probability of a disruptive tail event increases.
And there you have the investment case of Trump's trade war: a favorable outcome would lead to a modest, 4% rally; meanwhile, a full blown, "nuclear" trade war and there is no bottom in sight. While the Upside/Downside does not strike us as particularly attractive, especially when the basis of the assessment is the assumption of Trump's rationality, the bigger risk is that Trump himself may never have appreciated what Kolanovic said back in March, namely that a full blown trade war carries legitimate risks to Trump's presidency. If indeed so, as Trump is increasingly eager to make his point, then the increasingly likely outcome is that one proposed by Goldman over the weekend, namely that for Trump to win his trade wars, the market has to crash.