After a year of political turmoil culminating in a whirlwind of March departures of key staff including Gary Cohen, Rex Tillerson and HR McMasters, Trump may have finally resonated with the markets in the worst possible way. His announcement of China tariffs on March 22 sent the Dow plunging 724 points for the worst loss since Feb 8th.
The financial markets have weathered stories about the ongoing Russia Investigation, Trump affairs, turnover of key staff members, the firing of James Comey and Andrew McCabe, and threats of Nuclear War with North Korea. However, the reality of a trade war with China suddenly came to light after the announcement of tariffs on China imports and fear of retaliation from Beijing. Now that the long awaited tax break has been enacted, we are faced with a range of less attractive policy decisions that may have significant unintended consequences and no clear benefits. At best, they appeal to a narrow base of supporters. At worst, they serve to distract the public from the Russia Investigation at great cost.
Whether it be a trade war or military war, it raises uncertainty and risk to levels that are finally having significant negative impacts on the financial markets. Replacing McMasters with the famously hawkish John Bolton as the National Security Advisor only raises the fear of military action.
Four-Dimensional Chess, or Stumbling Around in the Dark?
While some will argue that this is all just a negotiating tactic on the part of Trump, the fact is that there has been a sea change of uncertainty in the markets this year, especially compared to 2017, the first year of this administration. That record low volatility period is suddenly a thing of the past and policy missteps have the potential to exacerbate risk further. While this may appeal to a small group of disenfranchised people who have not benefited from the financial markets, it is not welcome by jittery investors. Will Trump somehow release the pressure before a meltdown?
The uncertainty reflected in the increased volatility of the financial markets may be signaling more trouble ahead. Nobel Prize winning economist Robert Shiller is concerned that the uncertainty created by Trump’s policy and showman style will actually cause a recession. “A ramp up in U.S. – China trade tensions—which many are predicting in the wake of a new round of tariff threats from both sides—would immediately result in an economic crisis.”
Shiller goes further to say “It’s just chaos: It will slow down development in the future if people think that this kind of thing is likely.”
Contrast this from how the market responded to Trump throughout 2017 when the S&P had a record low volatility. Clearly we have a new dynamic working whereby Trump’s erratic policy decisions are no longer being ignored by the markets. If financial markets continue to be reflective of Trump’s policy chaos, we are in for a very bumpy road ahead and potentially a recession sooner than anticipated.
How Should Managers Model This?
From a risk modeling perspective, you may as well throw out the data from 2017 entirely because it reflects a completely different market regime than what we are currently experiencing. Any scenario analysis based on a low volatility, low correlation environment should be viewed as a best case scenario.
The probability of worst case scenarios such as recessions triggered by prolonged trade wars, military wars (we have a proxy war with Russia in Syria already and that is escalating with diplomatic sanctions as we speak), an impeachment or constitutional crisis are all increasing rapidly. This would be a good time to review your risk modeling decisions.