What can the Galton Board teach investors about the US trade policy changes?

Just a few minutes’ drive from President Trump’s boyhood home is the New York Hall of Science. The museum houses one of the world’s largest Galton Boards. A Galton Board is made up of rows and rows of obstacles, onto which a ball is dropped from a single point at the top. When a ball hits each obstacle it has a 50:50 chance of falling left or right, and after bouncing its way to the bottom, it lands in one of a number of pots (see Fig. 1).

Much of the media coverage of President Trump’s protectionist policies has made them seem like a game of Russian roulette, with no upside, and a meaningful risk of major downside. But we believe that the Galton board is a more apt analogy at this time: the protectionist ball has just dropped, and the outcome will only be determined after dozens and dozens of uncertainties have been resolved.

If Gary Cohn, the President’s former chief economic adviser can be surprised by policy changes being made in the next room, we consider the final outcome of US trade policy changes unknowable at this time. But while we are keenly focused on not underestimating the damage of a possible trade war, we believe it is simply too early to brace for an extreme bad outcome to US trade policy changes, and positive outcomes are not impossible. For the moment, economic factors like global growth and corporate earnings provide more valuable information for investors.

In the past month, growth has remained robust, the Fed has signalled that rate hikes will be gradual, and with that the threat of rapidly rising bond yields has cooled. We therefore have a pro-risk stance, are overweight global and emerging market equities, and have a regional preference for Eurozone stocks within Europe.

Yet the presence of heightened political uncertainty means we need to manage against downside risk. Doing this in a time of strong global growth is difficult, because the very positions that could be expected to perform well in our base case (e.g. our Canadian dollar, EM, and Eurozone positions) are also those which could be vulnerable in the event of a trade war.

We try to manage this challenge by keeping our pro-risk positioning, but at the same time also holding some counter-cyclical positions to help protect portfolios in the event of a negative surprise. We also look for opportunities that can perform well in both our base case and in case of a market downturn. These include our overweight in US 10-year Treasuries, our FX strategy overweight in the Japanese yen relative to the New Zealand dollar. This month we also trim the size of our overweight in the Canadian dollar within our FX strategy to manage against the risk that uncertainty over NAFTA negatively affects the CAD. For investors who can hold options, we also recommend considering a small allocation to a put protection strategy linked to the S&P 500.

The key uncertainties

Several phases of trade policy negotiation will take place before we know the medium-to long-term impact on the global economy and financial markets. Despite the uncertainty, we must do as much work as possible ahead of time to understand the range of scenarios that can unfold. This letter endeavours to walk you through our current thinking.

We think the market reaction to US trade policy will go through three key phases, and in each phase, we have been thinking about what might make the ball ping right, or left, on our Galton board.

How wide does US protectionism extend?

The most immediate uncertainty is how far protectionism might extend. The narrower the scope of industries targeted, and the fewer countries affected, the lower the economic impact, and the smaller the probability of retaliation and escalation.

Thus far the US has announced tariffs on aluminum and steel, while recently also adding further tariffs on Chinese imports stemming from the US investigation into intellectual property abuses. For context, the headline USD 60 billion is equivalent to around 10% of US imports from China.

We will be watching for the manner in which they are applied. The US has options on how it recoups the alleged cost of intellectual property violations. More targeted tariffs (for instance limited to intellectual property issues) are less likely to have an economic impact. Broad-brush tariffs (e.g. a unilateral 10%-or-greater tariff on trade with China) create a larger risk of retaliation.

Looking forward, there is a risk that US tariffs could extend even further. First, President Trump has emphasised stock market performance as a barometer of his success, and so a limited market reaction could embolden stronger action. Second, reducing the trade deficit is a stated aim of the administration, but tariffs are a weak tool for achieving this. The deficit is likely to remain high while the US economy is performing well. A perceived lack of progress in reducing the deficit could also embolden stronger action into the future.

How does China respond?

As we get greater clarity on the initial salvo from the US in the weeks to come, the next row of pegs on the Galton board will be how trade partners, and most crucially China, react.

The key downside risk would be if we see escalating tit-for-tat measures turning a trade skirmish into a trade war. China is very likely to react to US tariffs: not acting would be seen as political capitulation, and so tougher rhetoric is a minimum response. And ’proportional and justified’ retaliation is allowed under WTO rules for countries that believe they have been unfairly penalised. Harder action could involve China making it more difficult for US multinationals to do business in the country, or targeting sectors in which the US has a trade surplus and where substitutes are readily available, such as agriculture and vehicles. The US administration might then see China’s response as cause for further escalation.

But I think it’s too simplistic to say there’s only downside. “Linkage” remains an important but poorly understood part of US foreign relations. Negotiations may not only be about economics. Increased cooperation around other issues, such as national security, could be accepted by the US as ’payment’. In this regard, it may not be pure coincidence that apparent progress in talks with North Korea has come alongside the more robust US stance on trade. And the market could view the threat of tariffs as an upgrade from the threat of nuclear war.

The signaling effect of US tariffs could also provide potential upside. Today, the US has one of the world’s lowest levels of average tariffs, below those of China, the EU, Canada, and Mexico. President Trump’s chief economist Kevin Hassett has said the US is seeking “symmetry and reciprocity.” If this position is perceived as credible, other countries may be incentivized to reduce their tariffs with the US, rather than increase them.

The US position could be seen as analogous to a supermarket offering price-match guarantees. In retail, many supermarkets use such guarantees as a signal to tell competitors not to try and gain business by cutting prices (since price cuts would simply be matched, they would have no effect on market share and lead only to lower profits). In trade, a “symmetry and reciprocity” policy could have a similar effect: US trading partners could see that tariffs on US goods do not provide any gains, because they are reciprocated, and so might look instead to cut tariffs or improve relations in other ways. For example, Europe could agree to pay for a larger percentage of NATO or not install a new tax on large tech companies. China could offer to provide better protection of intellectual property rights, allow for greater market access, change rules for foreign direct investment, reduce subsidies of certain industries, ease local licensing requirements, or open up opportunities for investment into Made in China 2025.

We also shouldn’t neglect that closer trade agreements can still take place elsewhere in the world, and may even be spurred by fears of US tariffs. Just this month a Comprehensive and Progressive Agreement for the Trans-Pacific Partnership was signed, and the UK and EU27 have made progress on Brexit negotiations, agreeing to largely maintain existing relations until late 2020. The US is the world’s largest economy, but comprises just 9% of world exports and 14% of imports.

What is the central bank policy response?

Another factor to consider is the central bank policy response. Investors have come to rely on the ’central bank put’ option to insulate portfolios against market shocks. In the last ’test’ of this assumption, it proved valid, with central banks easing their policy stance significantly in response to the Brexit vote in June 2016.

We would expect central banks to lessen their tightening bias if it appears that growth is under threat from protectionism. But there is perhaps less certainty about this factor than two years ago. Central banks are further down the road to policy normalisation, unemployment is at multi-year lows, and output gaps have shrunk. Turning on the easing taps again may be harder than it was after Brexit – particularly if a trend of increased trade tariffs is seen as having ongoing inflationary consequences.

Asset allocation

There are scenarios in which trade policies could lead to negative outcomes for financial markets. We ascribe a 20–30% probability to a trade war. But positive outcomes, such as progress in talks with North Korea, and/or greater global trade cooperation should not be dismissed either.

With such two-way political uncertainty, and markets already pricing in fears of protectionism, we believe economics currently provides more useful information for investors than politics. And with economic developments largely remaining supportive over the past month we keep our pro-risk stance, and are overweight global and emerging market equities. Within Europe, we recommend an overweight to Eurozone stocks over UK equities.

However, the presence of uncertainty over trade means investors need to manage against tail risks. This is challenging in a time of strong global growth, because the very positions that can be expected to perform well in our base case (e.g. the Canadian dollar, emerging market and Eurozone equities, and emerging market FX and sovereign bonds), are also those that could be vulnerable in the event of a trade war.

We attempt to overcome this challenge by keeping our pro-risk stance, but also by holding some counter-cyclical positions, which could be expected to benefit in a market downturn.

These include an overweight position in US 10-year Treasuries relative to cash, and overweight in the Japanese yen relative to the New Zealand dollar.

In our FX strategy, we would also expect our overweight in the euro relative to the US dollar to benefit in the event of a trade war. Although the mechanical impact of US tariffs on the USD is positive, second order effects (e.g. fear of retaliation) are negative, and we believe that a weaker dollar is required to drive stronger US exports and a more balanced US current account.

This month we also reduce the size of our overweight positon in the Canadian dollar relative to the US dollar within our FX strategy. The CAD remains undervalued, Canadian economic conditions are good, and the real interest rate differential speaks in favor of the CAD over the USD. However, we are cautious that uncertainty over NAFTA could lead to more volatility in the currency in the months to come.

Elsewhere in our FX strategy, we overweight the British pound relative to the Swiss franc. The pound remains undervalued, and greater certainty over the Brexit transition is likely to clear the way for the Bank of England to increase interest rates in May.

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