Uncategorized

Markets: A trade war of attrition

| May 24, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Both the US and China at this point seem intent on wearing each other down in their trade war to the point where one side finds the prospective costs too high to bear. Each side probably has a fair idea of the costs the other might impose, but neither knows when the costs become unbearable. That’s invitation to steady, small tests of the other side’s willingness to continue. That’s trench warfare, and, for fixed income markets, steady volatility.

The headline costs for each side seem relatively clear. The imports, exports, companies, people and places involved are largely transparent. Data on international trade are plentiful. The gross costs are just a matter of which flows get hit with tariffs, by what amount and when. Both political leaders and their advisors should have a clear picture of the prospective stakes.

The net costs to each side may be a little fuzzier. The impact of tariffs depends on whether the exporter, the importer or the eventual buyers bears the cost. It depends on whether importers or buyers find substitute products. But economists have estimates of these nuances, so still the range of prospective stakes is presumably sketched out.

Both sides so far still seem more willing to escalate the trade conflict rather than deescalate. Each side must be assuming the other will eventually fold. The wildcard is pinpointing when costs on each side become unbearable.

Both sides likely have areas—economic and political—where the impact of trade war does become unbearable. Damaged economies, angry constituencies, volatile financial markets are on the list for both the US and China.  These things are arguably more visible in the US than in China, but political analysts argue that they exist in China nevertheless. But their very visibility in the US may give China an advantage in knowing the trade war’s impact. Still, it’s likely to be a hazy picture that takes time to clear.

Both equity and fixed income implied volatility lately have spiked as the markets have started to anticipate a steady, grinding confrontation. It’s plausible that the conflict could play well into next year and get either amplified or resolved depending on which endgame works best for the 2020 elections. Either side might run too high a political risk by folding before then.

Exhibit 1: Both equity and rate implied volatility lately have spiked

Source: Bloomberg

For fixed income investors, getting long volatility, or alternatively, buying convexity should be a valuable hedge.

* * *

The view in rates

Trade friction has already appeared on the Fed’s list of reasons to watch and wait, and it seems increasingly likely to tilt the Fed toward an ease. The market has already put a nearly 80% probably on a Fed cut this year. Threats to growth stand to compound concerns about low inflation as reflected in recent remarks by Fed Governor Lael Brainard. Explanations for low inflation vary, but the Fed seems to be appropriately focused on inflation expectations and ways to keep them anchored around 2%. Breakeven 10-year inflation continues to drop, recently hitting 177 bp. The likely fundamentals of long-run growth should keep long rates biased toward 3.00%, but, unless a new trade agreement is brokered, expect those yields to stay out of reach.

The view in spreads

Spreads in investment grade debt continue to widen as trade frictions pick up It’s an appropriate repricing as prospective global growth comes under pressure. Over the longer term, a relatively flat yield curve, low volatility and heavy net supply of Treasury debt should re-tighten spread markets, but the timing will depend on trade as well. The longer the Fed remains patient, the longer the spread advantage in assets other than Treasury debt compound to the advantage of portfolio return. Leverage and loosening of underwriting remain a concern in investment grade corporate debt and leveraged loans, but concerns about recession, which would trigger those vulnerabilities, have diminished. Agency MBS could see a softening of bank demand, but it should still outperform credit.

The view in credit

Companies have started to divert cash flow toward paying down debt, have started to sell non-core assets and have curtailed stock buybacks. Management has heard the concerns of debt investors. Households continue to look strong with low unemployment, rising home prices, and generally good performance in investment portfolios.

admin
john.killian@santander.us
1 (646) 776-7714

This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.

Important Disclaimers

Copyright © 2023 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.

In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.

The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.

In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.

Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.

The Library

Search Articles