Downfall In The Dow

It’s fair to say that Wall Street did not anticipate China’s retaliation to U.S. tariffs. Last week, the negative reaction to President Donald Trump’s announcement of new tariffs on China was oddly muted. On Monday, after China’s response was announced just before the market opened, the S&P 500 fell by more than it had done in the entire previous week.

It looks as though both the United States and China have underestimated the strength of the other’s position and willingness to escalate. Meanwhile Wall Street, which spent the time since the Buenos Aires “truce” in November busily working on the assumption that a deal was a given, has totally misjudged both sides. Why has China done this? I suggest that it is all down to the Dow Jones Industrial Average. Here goes one version of perception from China:

Trump measures himself by the Dow Jones Industrial Average. There is no reason to doubt this. Record markets have been taken as a presidential validation ever since the benchmark topped 20,000 in Trump’s first week in office. But there are three problems with this notion:

First, the odds are stacked against Trump from the start. He began with stocks already fully valued, and with interest rates low and bound to rise. These factors are far more important to the stock market than anything a president can do in office. Presidents who entered when stocks were cheap tended to oversee strong markets. By this measure, the most successful presidents in history were Bill Clinton and Barack Obama. Meanwhile, the S&P 500’s valuation when Trump took office at the start of 2017 was almost identical to its valuation when Herbert Hoover took office in 1929: 28 times cyclically adjusted earnings, according to Yale University economist Robert Shiller. It has since risen further, which is an impressive testament to investors’ optimism under Trump’s leadership, but further headway will inevitably be more difficult if the market starts from a more expensive position.

Second, at least two other organizations have more power over markets than the White House. They are the U.S. Federal Reserve and the Chinese Communist Party. Trump does not directly control either of them. The Fed’s volte-face on planned interest rate increases for this year helped to spur the recovery in stocks, and a series of ever more insistent presidential tweets makes it clear that Trump would prefer the central bank cut rates, not just keep from raising them.

Moves in China’s domestic economy have an outsized effect on stocks in the developed world. To demonstrate this, look at how the 100 stocks in the MSCI World Index of developed-market stocks with the greatest exposure to China have performed compared to the MSCI World Index as a whole:

When China is slowing down, as it did last year or in 2015, world markets sell off. Once it starts to stimulate, as in 2016 or in the first few months of this year, developed-market stocks start to roll.

Third, a higher stock market is not what the people who voted for Trump wanted. Indeed, it may even run counter to it. After years of intensifying inequality, higher share prices would tend to exacerbate inequality. Higher wages and more jobs, which is what the Trump electorate needs, tend to cut into profit margins and reduce share prices while raising interest rates. And big American companies derive a huge chunk of their income from overseas. Bolstering the stock market is not consistent with an “America First” policy.

 

Why is Trump behaving this way? Because higher tariffs offer him the chance to square this circle. By raising tariffs he puts pressure on China to stimulate its economy. That, in turn, will tend to lead to a recovery in U.S. share prices. It did so quite spectacularly in 2016. By amping up global tensions, pushing down on risk asset prices and raising uncertainty, Trump also puts pressure on the Fed to cut rates. In the last week, the chance of a Fed rate cut by the end of the year has shifted from 50 percent to more than 75 percent, according to data compiled by Bloomberg:

If Trump can get both China and the Fed to resort to stimulus at the same time, and then reach some type of deal with China, then that should be enough to push stock markets to new record highs. (It should also help spur the economy just in time for next year’s election.)

Added to that, Trump’s actions to push up the Dow are also great politics when judged more conventionally. Getting tough with China involves doing exactly what he said he would do, which is always popular with the electorate. It is a posture that is also popular with many Democrats, and the party is already having difficulty knowing how to respond. On this basis, it is an almost cost-free strategy for a president who values himself in the Dow’s performance. Plenty of forces are pushing the two sides toward an eventual deal anyway. All the game theory everybody had done before last week was not wrong. Amping up the stakes at this point was good politics and even—despite appearances—aided in the apparently impossible job of pushing up a stock market that already appears to be amply fully valued.

The problem is that China knows how to respond. China can see all of this, and it knows it can attack the presidential weak spot by acting in a way that damages the Dow. Hence, it not only retaliated with tariffs of its own, but announced them just as the New York market was about to open, at night in China, for maximum effect.

Now we come to the limits of the two countries’ powers. China imports less from the United States than the United States imports from China, which is why Trump is taking action in the first place. This means that China’s scope for imposing further tariffs is limited. What it could do is weaponize its foreign-exchange reserves and start selling some of its holdings of U.S. Treasuries. This would have the effect of forcing U.S. bond yields and borrowing costs higher. But it would also tend to reduce the value of China’s remaining hoard of Treasuries.

Meanwhile, the United States can still impose more tariffs, but the goods it has chosen to attack have been largely invisible to consumers. Any further tariffs will take it into consumer products where price rises will be visible and painful, and might even, again, act as a spur to raise rates.

Armed with this logic, the market may well decide that the hostilities will go no further. But if investors truly want that outcome, they may find it necessary to put more pressure on Trump by selling stocks. It may be obvious that a resolution will result, but markets will have to go through the process of a big sell-off to get there.

After The Fall

After the credit bubble burst in late 2007, my prediction (along with that of many others) was that we would watch stocks settle into a classic drawn-out bear market. After a drastic decline, they would trade sideways for years on end, sometimes enjoying sustained gains but then suffering prolonged slumps. This is what happened to the Dow Industrials after the great crash of 1929 (in red below), the Nasdaq Composite after the dot-come bubble burst early in 2000 (shown in purple), and Japan’s Nikkei 225 after its great bull market peaked on New Year’s Eve 1989. In the United States, stocks have confounded such predictions. But if we look at the MSCI ACWI index excluding the United States, an index that effectively covers all the world’s non-American stock markets, we can see that the pattern is indeed similar to the previous great post-bubble bear markets. It is shown in white:

Yes, non-American stocks have done somewhat better than the markets that suffered those historic busts, but the pattern has obvious similarities. Now, let’s compare the S&P 500 with the rest of the world over the same period:

Even after the sell-off of the last few days, America’s recovery seems scarcely believable. It flouts historical precedents. And it has little to do with the doings of presidents Obama and Trump. It looks as though the U.S. stock market has dodged a post-bubble reckoning. Can it really continue to do so? And is it really a good idea to stake a political position on it doing so?

Dear Chairman

Just a reminder that the Authers’ Notes book club is up and running again. Our latest book is Dear Chairman, a brilliant and engaging history of shareholder activism by Jeff Gramm. If you want to join in the conversation, we now have an Instant Bloomberg chat room dedicated to book club members on the terminal. Send an email to [email protected] and we can get you involved. This week we will be discussing the activism of Benjamin Graham and a young Warren Buffett, and the post-war “proxyteer” movement. It will be fun. Let’s chat.

This article was provided by Bloomberg News.