One week / one topic: New world order

What happened?

Last week marked a dramatic climbdown in volatility across markets, as investors (partially) absorbed the emotional and cognitive shock brought about by the ‘Liberation Day’ announcements.

Global equities are down ~5% since and 10-year Treasuries are essentially flat. No biggie, did you say?

Now, I have to confess that I find any argumentation along the lines of ‘Prices are just back to where they were x weeks ago!’ more than a little specious.

As an example, global stocks are at levels last seen in mid-August – but we are facing very different conditions for any number of reasons, the level of underlying uncertainty is radically higher and the world has kept changing ever since... like it always does.

In focus of course is the fact that recent developments could potentially amount to no less than a radical restructuring of the long-established legal, logistical and physical infrastructure of global trade.

Alas, there is nothing new under the sun (h/t James) and – despite disastrous historical precedents, plus the numerous walk-backs since the initial announcement – the US effective tariff rate is still the highest since at least the 1930s.

To summarize where we are, Howard Marks – in (yet another) high-quality memo – listed president Trump’s reason for enacting tariffs as to:

• support U.S. manufacturing

• encourage exports

• discourage imports

• shrink or eliminate the trade deficit

• make supply chains more secure through onshoring

• deter unfair trade practices aimed at the U.S.

• force other countries to the negotiating table

• generate revenue for the U.S. Treasury

While every one of these reasons might indeed be ‘desirable in itself’ from a US perspective, Marks goes on to list some of the likely consequences as:

• retaliation by other countries

• price increases and rising inflation

• destruction of demand due to price increases and declining consumer confidence

• recession and lost jobs, both in the U.S. and around the world

• supply shortages

• a massive change in the world order

While the fast-money crowd clearly reacted very quickly to the various announcements over the last couple weeks, it feels like the arbiter of market outcomes might well be foreign structural holders of US assets from this point forward.

After all – if you are a European, Chinese or Japanese investor – you don’t have to own as much of your portfolio in US assets, especially now that the President has made it abundantly clear that this is a competition game and not a cooperation game.

Capital does tend to flow to where it’s treated best…

So, what now?

Is this mostly about regional asset preferences, or is the real question “how much risk do you want in your portfolio?”

Our observations

• Fundamentals: While we wait for the hard data to catch up with surveys, recent corporate guidance has been intentionally vague about capex and hiring intentions given the underlying bimodal distribution of outcomes. (Deal or no deal?)

• Price action: If foreign investors have indeed lost confidence, it’s hard to shake the feeling that we ain’t seen nothing yet. If so, it’s going to take a long time to reverse the massive US overweight present in many portfolios…

• Investor beliefs: Did the ‘buying opportunity’ come and go already? Or is patience going to be ultimately rewarded?

So what?

It seems that there are two key questions that investors need to answer and, unsurprisingly, they are closely related:

• Does he mean it? Or is this all just negotiation tactics, and the final outcome won’t be that different from the status quo in the end?

• As no one know the answer to the previous question, is the massively high uncertainty injected into the system enough to trigger a recession?

As we’re dealing with radical uncertainty, it is perhaps best then to focus on what feels appropriate in the current context.

With that in mind, we have recently implemented a few portfolio changes:

• Reduced overall equity allocation from 45% to 40%

• Increased our preference for Japanese, European and EM equities vs the US

• Reduced portfolio duration by swapping some of our 30yr US Treasuries for 10yr ones.

Sure, woe betided anyone who dared being underweight the US stock market over the last 15 years… but the antigravity properties of its forward earnings expectations look increasingly questionable in the current environment.

Mood music: Mary J. Blige – No More Drama