Swedroe: The Drums Of (Trade) War
As the director of research for Buckingham Strategic Wealth and The BAM ALLIANCE, I have been getting questions from investors who have become very concerned about the potential for a global trade war, a war in which there are not any real winners.
Of course, that worries investors, especially those who were taught that the Smoot-Hawley Tariff Act enacted in 1930 was a major contributor to the Great Depression. (While it certainly did not help, the causes of the Great Depression go way beyond that single law and the depth of the recession can most likely be attributed to poor monetary policy and poor fiscal policy decisions by governments and central bankers around the globe.) These concerns have many investors wondering what, if anything, they should do. I hope the following is helpful in answering that question.
A Few Key Considerations
First, and most importantly, whenever you are worried about an issue, whatever it might be, you should stop and ask yourself this question: Am I the only one who knows about this issue? Clearly, the answer is going to be “no.” That must mean the smart portfolio managers at hedge funds, investment banks and mutual funds also are aware. That, in turn, must mean the information—the estimated odds of the event actually occurring—already is embedded into current prices. Thus, unless you somehow believe you know more than the collective wisdom of these professionals, who do about 90 percent of the trading and so set prices, it is too late to act. The right answer, then, must be to do nothing.
Second, I suggest asking yourself if it is reasonable to assume that Warren Buffet is aware of the situation. Again, the answer will surely be “yes,” and he probably isn't doing any selling. So again, unless you think you are smarter than he is, you should take his advice, which is to avoid trying to time the market.
Third, remember that an overwhelming amount of evidence shows that active managers are highly unlikely to generate alpha by timing the market (or by picking stocks, in this case the ones that will benefit from a trade war, and avoiding those that will suffer the most). Consider that over the last 15 years, using data from Morningstar, which includes survivorship bias, passively managed, structured portfolios from Dimensional Fund Advisors, which have ignored all the economic and geopolitical news, have outperformed 82 percent of all active funds, on average. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends Dimensional funds in constructing client portfolios.)
If we account for survivorship bias, that figure rises to 90 percent. What’s more, that’s pretax. Because actively managed funds’ greatest expense typically is taxes, for taxable investors even that figure is too low. Why would anyone want to take active management in that bet? It’s why Charles Ellis called active management the loser’s game; it’s a game that’s possible to win, but the odds of doing so are so low the prudent strategy is not to play.
Finally, there are a few things we likely can say. In a trade war, relatively speaking, the United States tends to do better because trade is a much smaller percentage of our gross national product than it is for most countries. This likely explains much of the outperformance year-to-date of U.S. stocks. Small-cap stocks tend to do better than large-cap stocks because they tend to be less exposed to world trade. Again, this likely explains some of the outperformance year-to-date of small-cap stocks. In addition, the dollar tends to strengthen due to investors’ flight to safety and liquidity. Conversely, international stocks tend to do worse and emerging market stocks tend to do the worst of all because their economies tend to be more reliant on globe trade. Furthermore, their currencies take a hit from investors’ flight to safety. This is a double whammy, as much of their debt tends to be in dollars (which are appreciating relative to their own currencies, making debt financing more expensive). That's exactly what has already happened as the risks of an all-out, global trade war have increased.
As the market expects the odds of a trade war to rise, you see more of this type action. Then, when the odds of a bad outcome seem to decrease, the reverse occurs. As I previously mentioned, the increasing risk of an all-out trade war likely explains the relative performance of stocks; it’s contributing to why U.S. stocks and U.S. small-cap stocks are outperforming. It also could help explain why, despite the strong economic data reported, Treasury bond yields came off their highest levels (Treasury bonds benefit from flights to quality, safety and liquidity, and investors could be concerned about lower economic growth as well).
Possible Outcomes
Again, it’s important to understand that all this information is already in prices, and we don't know how the game will end. We are only in the middle innings. If the White House’s strategy of confronting our trade partners works, and all tariffs come down, it will be a huge win for the world, not just domestically. In that case, stock prices likely would rebound sharply while bond yields likely would rise. International stocks would do better than U.S. stocks, and emerging markets would recover the most. Of course, that is an “all-else-equal” statement, and all else is never equal.
On other hand, an all-out trade war conceivably could lead to lower economic growth around the world, with the U.S. least impacted. That could forestall any further interest rate hikes from the Federal Reserve as it becomes concerned about growth. Alternatively, it could also lead to spikes in inflation, as not only would the cost of many imports rise, but the competition for domestic producers would be lessened, allowing them to raise prices. That is why no one “wins” trade wars in the end. Some industries may at least temporarily benefit (like, in the current tariff situation, domestic steel producers and their workers), while others lose (as the cost of steel rises, raising prices on all types of products from cars to canned goods).
There’s another important point to consider, again demonstrating that prices already reflect what is knowable. The following table shows the current valuations for U.S., developed market and emerging market stocks. Clearly, U.S. stocks’ higher valuations reflect the view that, in the collective wisdom of investors, the stocks of other developed nations are riskier and the stocks of emerging market countries are riskier still. Because current valuations offer the best estimate of future returns, investors seeking the safety of U.S. stocks are accepting lower expected returns. Of course, that doesn’t mean the higher expected returns of international developed markets and emerging markets makes them superior investments, just riskier ones for which investors require that higher expected returns as compensation for assuming incremental risk. The data is from Morningstar, with portfolio information as of the end of May 2018.
| Price-to-Earnings | Price-to-Book | Price-to-Cash Flow |
17.1 | 2.9 | 12.8 | |
14.1 | 1.5 | 5.0 | |
12.3 | 1.7 | 5.1 |
Using a selection of funds from Dimensional, we see the same thing when we look at value stocks. In particular, note that emerging market value stocks are trading at about one-half the P/E ratio of stocks in the S&P 500 Index. International small-cap value stocks and emerging market stocks are trading at below book value while stocks in the S&P 500 Index are trading at almost three times book value. That spread reflects the difference in views regarding their relative safety.
| Price-to-Earnings | Price-to-Book | Price-to-Cash Flow |
14.3 | 1.3 | 6.4 | |
11.1 | 0.9 | 3.7 | |
9.1 | 0.9 | 3.1 |
The bottom line is that investors should build the risks of events such as trade wars into their plans and asset allocations in the first place. There are always many different potential risks and black swans out there. If issues such as these cause you to panic and sell, I would suggest you have too much equity exposure to begin with. Investors need to learn to differentiate information (i.e., there is a possibility of a trade war) from what is called value-relevant information (which you can exploit because others either are unaware of it or you can interpret it better).
In virtually all cases, any economic or geopolitical news is not value-relevant information, unless you have a copy of tomorrow's newspaper. The winner’s game is to adhere to your written and signed, well-thought-out plan (assuming you have one) and to ignore the noise of the market. The only time you should change your plan is when any of the assumptions about your ability, willingness or need to take risk have changed.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.
