Swedroe: The Drums Of (Trade) War

July 13, 2018

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).

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