How Trump's potential trade war will impact the U.S. stock market

We briefly discussed this in our market outlook on Friday.

Over the past few months, Trump’s advisors have strongly advised against a trade war. And over the past few months, Trump has listened to his advisors. But with Trumpcare stalling in Congress and his pro-growth policies on hold, Trump is finally lashing out.
According to a report from Axios, Trump had a meeting with 24 Cabinet members and top government officials on Thursday. While the majority of participants were still against slapping tariffs on American imports, Trump supported tariffs.
The report said that a decision will be made in the “coming days”. The primary target will be Chinese steel exports. It may be extended to other goods.

We’d like to discuss this in detail because we were completely blinded to this risk. Over the past year, Trump has talked a lot about trade wars and tariffs but never followed through on any of his threats. We focus on action and not talk.
We care about Trump’s potential trade war ONLY to the extent that it impacts the S&P 500. We don’t care what economic theory says about trade wars. Economic theory is almost useless because it’s based on the assumption of ceteris paribus, which is a ridiculous assumption.

What are mainstream investors afraid of?

Investors aren’t really concerned about Trump slapping tariffs on China. Obama did it and nothing bad happened.

  1. Obama slapped a 35% tariff on Chinese tires in 2009. There was no trade war, the U.S. economy didn’t tank, and there was no significant correction.
  2. On May 2016, the U.S. increased tariffs on Chinese steel to 522%. There was no trade war, the U.S. economy didn’t tank, and there was no significant correction.

Europe also imposed tariffs on China, and nothing bad happened.
Investors are concerned about the slippery slope. “If Trump slaps tariffs on Chinese steel, will he start arbitrarily slapping tariffs on other imports from other countries as well? Will China retaliate?”
Let’s think this through rationally.
*Trump does not need Congress to slap tariffs. He can do so himself on grounds of “national security”.

Will Trump slap tariffs on Chinese steel?

Trump’s rationale for slapping tariffs on China is very easy to understand. It has nothing to do with “protecting American industry”. It’s politics as usual.

Trump has 2 sides – Good Trump (pro-growth policies) and Bad Trump. He tried being Good Trump over the past few months. It didn’t work. Healthcare reform got shutdown, and his tax cut / infrastructure spending plans went nowhere. He desperately needs a political win. Otherwise he’ll be accused of not following through on his campaign promises. So he needs to make an example out of China. He’s not looking for a full blown trade war with Germany, Mexico, Canada, etc. He’s looking to make flashy headlines and say “see! I told you I’d punish China! I followed through on my promises! I’m the best guy in the world. Believe me. Nobody is better than me.”

We think fears of Trump slapping tariffs on Chinese steel are overblown. The G20 is meeting on July 7-8 (next Friday). China Daily stated that Chinese President Xi Jinping is looking forward to “a constructive and results-oriented relationship” with President Trump and the U.S.
*China Daily is not a media site like the NYTimes or Washington Post that can make up BS to fit a political angle. China Daily is the mouthpiece of the Communist party because it’s owned by the Communist party. If you’re a Chinese journalist and you make things up about the Chinese president, you go to jail.
Xi has a lot on his mind right now. China will host the 19th National Congress of the Communist Party of China. This is a huge deal for Xi. It is a once-every-5-years event that determines the future makeup of China’s top leaders.
Hence, Xi is preoccupied with political maneuvers at home. The last thing he wants is to be embroiled in a trade war with Trump. As a result, he has 2 options:

  1. Play nice with Trump at the July 7-8 G20 meeting and give into Trump’s demands (whatever those demands are).
  2. Not give into Trump’s demands and get hit with a steel tariff.

It’s reported that Trump will wait until mid-July (i.e. after the G20 meeting) to decide whether or not he’ll slap tariffs on China.

How we think this will play out

The odds of both scenarios are 50-50.

  1. If Xi gives into Trump’s demands, that’s the end of the story. This is no longer a concern to the U.S. stock market. There is no trade war, and Trump can come home a “big winner”.
  2. If Xi doesn’t give into Trump’s demands, we don’t think Xi will significantly escalate tensions.

Xi has too many internal and political problems on his mind right now! Yes, China will probably slap some small and insignificant tariffs on U.S. exports just for show. That’s politics as usual. But Xi does not want a full-blown trade war. In any U.S.-China trade war, the U.S. has the upper hand. China is an exporter and America is an importer. Why would China fight a trade war when they know they can’t win?
In addition, even Chinese leaders acknowledge that China is producing too much steel and forced to dump it on the rest of the world!
If the trade war doesn’t escalate, than any small correction in the U.S. stock market will not turn into a significant correction.

How we’re going to trade this

We’re sticking to our original plan.

  1. Our medium-long term model says that the U.S. stock market is still in a “big rally within a bull market”. There is no significant correction on the horizon.
  2. We are sitting on 100% cash. Based on our Easy Trading model, the most risk-free and guaranteed part of the current “small rally” is over.
  3. We’re waiting for the next 6%+ small correction. Then we’ll shift into 100% long UPRO (3x S&P 500 ETF).

*Our medium-long term model doesn’t use politics as a component.
Could a Trump-China trade row be the trigger for a 6%+ “small correction”? Who knows. Right now, we don’t even know if there will be a trade war. A trade war would certainly benefit us since we’re sitting on cash and looking to buy UPRO.
The S&P is now in the 96th percentile of all “small rallies”. When a small rally becomes this aged, anything can be the trigger for the inevitable small correction.
*It has been 257 trading days since the last small correction. Only 3 “small rallies” have lasted longer.

  1. 335 trading days (October 5, 1992 – January 31, 1994).
  2. 297 trading days (December 9, 1994 – February 13, 1996).
  3. 284 trading days (November 16, 1988 – January 3, 1990).

What if the trade war escalates and the “small correction” turns into a “significant correction”?

*As prudent investors, we need to always consider the worst case scenario.
Stock market investors/traders are lucky. Historically, the S&P tends to “climb the wall of worries”. When big problems first develop, the S&P tends to ignore the problem and continue to rally! For example, signs of Greek/European problems first emerged in December 2009. But the S&P’s “big rally” continued until late-April 2010. The S&P began a “significant correction” more than 4 months AFTER the European problem started to develop!
*The S&P tends to “climb the wall of worries” because there is too much “dumb money”. The dumb money ignores bad news until the bad news is so obvious that it can’t be ignored.
So if the Trump-China trade war escalates, there is no need to panic and sell everything immediately. The S&P will probably continue to consolidate or rally (i.e. ignore the worries).

  1. If the trade war escalates, we will wait for the situation to develop and become painfully obvious before selling our UPRO.
  2. If the trade war doesn’t escalate, then this is not a medium-long term concern. The small correction will not turn into a significant correction.

We are open to changing our thoughts on this issue as the facts change. Good investors need to be flexible and admit when they are wrong.

Leave a Comment