A Strange Game

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Mutually Assured Destruction

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Life imitates art…we hope. In the 1980s film War Games, computers learn there is no way to game a nuclear war because everyone loses. Sadly, Xi and Trump have failed to arrive at that basic realization about trade wars. Until they see the futility of fighting and start a conversation, markets will be burdened by a stalemate between an unstoppable force and an immovable object. Investors hoping that a deal will get done have kept markets somewhat orderly, but that only postpones an authentic negotiation. We believe the only motivating factor that gets these two leaders to make a deal is the fear of liquidity seizing up that will arise on a violent drop in stock prices.

The negative face of the trade war is beginning to emerge. Citibank Asia notes that Chinese shipping company bookings for certain goods have already been cut by half. Citi strategists project a 39.5% decline in global trade—a shocking number. Unfortunately, Trump may become emboldened in his tariff crusade if he sees the bank forecasting the total U.S. trade deficit dropping to $500 billion. Adding back the tariff revenue, the trade deficit falls below $200 billion. That is a massive 85% reduction from the pre-tariff deficit of $1.3 trillion. Furthermore, the expected future damage to the Chinese economy will make Washington wait for Xi to initiate talks. The export industry drove a third of China’s 2024 growth, and Goldman Sachs forecasts 20 million Chinese jobs could be lost from this trade war. Fewer jobs lead to a drop in Chinese consumption, making for an even bigger deflation problem for Beijing.

In addition to lower demand, the sharp drop in U.S. exports will bloat Chinese inventories; that added domestic supply will also drive prices lower. Major e-commerce players such as Tencent have offered to help exporters reposition themselves to Chinese consumers to deflect some of the pressure from drastically lower export volumes. However, this still does not address the central issue of strengthening fragile consumer sentiment. A weaker Chinese economy will have broad secondary effects, leading to even lower global growth, which will pressure trade flows even further.

For now, there are no signs of reconciliation. Trump thinks he has the upper hand, and Xi does not have any re-election pressure pushing him to make concessions. A famous line from  War Games is “A strange game. The only winning move is not to play.” If stock market participants tire of waiting for Xi and Trump to recognize this obvious point, investors may stop playing. At that point, we are in for another wave of market volatility. We hope it does not take another stock drop and the ensuing fear of a liquidity crisis to get the two countries talking. However, the longer the impasse, the higher the probability of a renewed stock selloff.

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Whites of Their Eyes

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We have a problem if there is a problem. The Fed is frozen in its policy making. It cannot be forward looking because it is impossible to have conviction, not only about the final version of U.S. trade policy, but how those tariffs would work their way through the economy and impact growth. This built-in hesitancy guarantees a lagged rate response until either inflation or unemployment has moved up significantly. Waiting to see the whites of inflation’s eyes before firing off a rate response could risk an entrenched rise in inflation expectations.  

Jerome Powell finally matched Bank of Canada Governor Tiff Macklem’s candor when the Fed Chair said last week that the significantly larger-than-expected tariffs will lead to higher inflation and slower growth. Last week, Macklem’s economic staff published the results of a bearish scenario with permanent tariffs, producing a one-year recession for Canada and the U.S, with rising prices.

Powell mentioned the potential dilemma facing the Federal Open Market Committee (FOMC) from such future stagflation:

We may find ourselves in the challenging scenario in which our dual-mandate goals are in tension.

That inherent tension breeds indecision, because a rate cut addresses growth but can fuel even higher inflation, while a rate hike tries to cap inflation but risks a deeper slowdown. Secondly, the FOMC will need to see how fast goods inflation rises versus services disinflation, and that internal movement within the inflation mix creates the need to observe first before acting. Services inflation has been stubbornly high, but if people are forced to pay more for goods, it leaves less disposable income to buy services. Services have been supported by expansionary fiscal policy, so if that stimulus is withdrawn, that is a second factor that will reduce services inflation.

Too many moving parts create the need to step back and answer two questions: how big an impact will tariffs have on inflation and growth, and what will be their duration? Until those questions can be answered, do not expect a major change in monetary policy. Again, we expect the markets or the economy to force the Fed’s hand. In that respect, Xi and Trump are acting in the same play as the FOMC.

‍Goodfellas

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A member of Japan’s 2^nd most popular party just trash-talked the United States. Shinji Ojuma of the center-left Constitutional Democratic Party of Japan described the U.S. tariff plan as inconsistent, “completely unreasonable…the equations nonsensical…It wasn’t a decision made after much deliberation.” Ojuma-san described the Trump administration as an opponent, adding:

He is really mocking the world…it’s akin to being extorted by a delinquent. If Japan gives in, thinking it’s a negotiation or a deal, and compromises on its position, it sets a bad precedent…If you give money to someone extorting you, they will just come back to extort you again.

We cannot forget that the Japanese are close allies who, on the floor of the National Diet, are describing the administration in Washington as Yakuza. We expect a chorus of complaints about American hubris when finance ministers and central bankers meet at the IMF this week. Normally, IMF meetings forge a consensus that is aligned with U.S. views. Undoubtedly, our allies are going to unify, but they may sound more aligned with Putin and Xi’s view of America. This could set a more combative tone in trade negotiations. We are going to look out for negative comments coming from our allies during their week in Washington and see if they move the market.

If the rest of the world is not going to comply as Washington expects, then equity investors’ cautious optimism could collapse if the trade talks turn contentious.

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‍What to Look for This Week

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(All times D.S.T.) 

1. Friday, April 25 at 10:00 a.m. University of Michigan Final Survey of Consumers for April. The market moving statistic is their 5-year inflation expectation data, which has risen from 3.0% in January to 4.4% for the preliminary April figure. The explosion in the range of responses between the 25^th percentile survey reading (under 2% inflation expected in 2030) and the 75^th percentile (around 10%) is making the FOMC question the survey’s validity.

2. Thursday, April 24 at 8:30  a.m. Durable Goods for March. We will look at Non-Defense Capital Goods Orders Ex-Aircraft, which fell in February and is a good indicator of business spending. March Existing Home Sales data is released at the same time, and lower mortgage rates for March may have brought in more buyers than expected. Big data day: at 1:00 p.m. Atlanta Fed GDPNow release could grab investors attention. It has been languishing below -2% recently and is forecast to drop to -3.7%, matching the low for the year. We watch the alternative market forecast which adjusts for gold import and export flows, which was last reported at -0.3%.

3. Wednesday, April 23 at 9:45 a.m. S&P Global Composite PMI for April. Normally not a highlight, but March input prices saw the largest increase in two years, so that is a datapoint we will be watching in the April report.

FOMC Voters Speaking:  Fed Vice Chair Jefferson Tuesday, April 22 at 9:30 a.m., and Governor Kugler after the market close that day at 6:00 p.m. Wednesday, April 23 at 9:35 a.m. Governor Waller speaks. At 2:00 p.m. Wednesday, the Beige Book is released. Chicago Fed President Goolsbee Thursday, April 24 at 9:00 a.m. Fed blackout period starts Saturday until the May 6-7 meeting.

IMF Meeting: April 21-26 Finance Ministers and Central Bankers from around the world meet in Washington to discuss global developments. Markets will hope for some progress on tariffs stemming from the meeting.

Earnings Note: Tuesday, April 22 Tesla and SAP. Wednesday, April 23 , IBM and Texas Instruments. Thursday, April 24 Google and Caterpillar and Union Pacific. While Google will get the attention, CAT could lend good insight about the health of the global economy, and UNP could lend insight for goods shipments within the U.S.