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MODELING TRUMP’S TRADE WAR

As the market looks ahead in 2018, the global economy appears to be undergoing a synchronized upturn. Our base-case scenario still calls for an equity market blow-off, followed by a Fed-induced slowdown (see our publication, Five Steps, Where’s the Stumble?). In the midst of the celebration, American trade policy is starting to appear as a risk to the equity bull.
However, 2018 may bring “full Trump”, with a dramatic change in policy tone after the legislative tax cut victory. Both the news site Axios and the Washington Post reported that the Trump Administration is preparing to announce a series of trade sanctions on China in January.
While we are not forecasting a trade war-induced bear market, good investors engage in scenario modeling in order to be prepared for different possibilities. We explore the ramifications of a trade war as an exercise in preparation.
We find that prospect of trade sanctions and protectionism is likely to be a shock to the stock market. Should such a scenario unfold, the most likely outcome is Petersen Institute’s modeled “aborted trade war”, whose first order effects sees growth slow, but the economy avoids a recession. The stock market would likely react by entering a correction.
However, the second order effects of trade policy are more difficult to forecast. Should a trade war erupt, we would monitor the reaction of both the Chinese authorities. As well, we would monitor developments in inflation, and inflationary expectations in order to better forecast the Fed’s reaction to a likely trade-induced slowdown.
Technical analysis can also provide some clues about the likelihood of an equity bear market. The global stock market historically did not top out spontaneously in the last two cycles. Instead, the topping process saw an initial peak, a correction, followed by a second rally to either test the previous highs or make a new high, but with a negative divergence on the 14-month RSI. If a trade war were to spark a bear market, we would look for a similar technical pattern seen in previous major tops.