As any market follower knows, there has been an abundance of news over the past 3 months essentially telling market participants that a trade deal is imminent. It is tough to say why such obvious market jawboning was dismissed, but the time is here to wake up to reality. I also want to bring up that these past 3 months have made me wonder if news algorithmic trading programs have the ability to exhibit headline skepticism, but that’s another conversation.
Below, you will find the tweet that has caught market participants off guard. It is now apparent that the trade war is in fact not coming to an end any coming Friday, but in fact getting taken to the next level.
So why did this happen and what are the ramifications?
One can speculate that Trump was not getting all he asked for in the deal room with Xi. I think what is important to remember is that Trump is up for reelection in 2020 and Xi is a lifetime leader. If Xi is unsatisfied, then he can simply wait for the next President.
Forecasts for the 2020 election become key in understanding the dynamics of the situation. We know that Trump is largely running on the use of an economic scorecard. If the scorecard looks good by 2020, then Trump is likely going to win and vice versa. The economic scorecard basically consists of the stock market, GDP, and unemployment.
Please view an overly simplistic decision tree below.
Trade Deal-Market Rally-Trump Wins 2020 Election
Trade War Intensifies-Market Sells Off-Trump Loses 2020 Election
The point is that Xi has the luxury of time and will use that to his advantage to basically choose who opposes him in the deal room.
Moving on. Why did this really happen?
Is Trump performing some sort of “Art of the Deal?” Maybe in his mind.
But perhaps, he is aware that GDP is due to come in weaker in quarters to come with the huge inventory builds. He does not appear able to get Powell to cut rates in order to pull demand forward, so maybe he has decided to attempt to influence the GDP number. One thing that I think is fairly straight forward is that if we are in an official recession by 2020, then Trump has no chance of winning the election. So, let’s assume that Trump knows that future GDP may be under threat, and he understands that he does not have monetary policy in his arsenal at the moment, then what does he do?
He tariffs (taxes) domestic producers’ imports in order to influence them to build inventories again. Theoretically, this could short-term boost GDP as it did with the last round of tariffs. From the chart below, it is apparent that the level of contribution of inventory to GDP mean reverts around 0%. This should make sense intuitively as businesses build inventories one period, they are less likely to need to build inventories in the next period as well.
I will wrap this up with some things to watch out for.
Will the yuan depreciate against the dollar again to offset the tariff?
Will tariffs of this magnitude spur inflation as producers have to pass tariff costs to consumers?
Will producers who are already sitting on large inventory hordes build again?
At what level on the major indexes will Powell announce that QT will end before the expected September 30 date?