Swedroe: The Drums Of (Trade) War

July 13, 2018

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
Vanguard S&P 500 ETF (VOO) 17.1 2.9 12.8
Vanguard FTSE Developed Markets ETF (VEA) 14.1 1.5 5.0
Vanguard FTSE Emerging Markets ETF (VWO) 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
DFA U.S. Small Cap Value Portfolio (DFSVX) 14.3 1.3 6.4
DFA International Small Cap Value Portfolio (DISVX) 11.1 0.9 3.7
DFA Emerging Markets Value Portfolio (DFEVX) 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.

 

 

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