Macro: Sandcastle economics
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How to trade the trade war
Peter Garnry
Chief Investment Strategist
Summary: The return of harsh tariff threats from Washington ahead of the expected arrival of a Chinese delegation this week has financial markets spooked, with a significant downside move probable if the VIX volatility index ticks past 22.
It’s always calmest before the storm. Today, markets have shifted gears in volatility terms with tensions up sharply from the recent, historic calm across all asset classes. President Trump’s sudden tweets last night about the slow pace of the US-China trade deal negotiations have bumped up the VIX index and sent Chinese equities lower (the CSI 300 Index futures ended the session 6.4% lower).
With historically high net short positioning in VIX futures (short volatility strategies), the market is set up for severe downside dynamics should the VIX take up the critical levels around 22 (the index stood at 17.40 ahead of today's New York bell). China’s trade negotiators are planned to arrive in Washington on Wednesday and it is very likely that Trump’s tweets are a negotiation tactic in order to press the Chinese for a trade deal sooner rather than later.But what's next for financial markets?
With historically high net short positioning in VIX futures (short volatility strategies), the market is set up for severe downside dynamics should the VIX take up the critical levels around 22 (the index stood at 17.40 ahead of today's New York bell). China’s trade negotiators are planned to arrive in Washington on Wednesday and it is very likely that Trump’s tweets are a negotiation tactic in order to press the Chinese for a trade deal sooner rather than later.But what's next for financial markets?
As we wrote in our recent Equity Monthly update, we are still in a macro environment where bonds typically have outperformed equities, so investors should still be defensive and underweight equities relative to bonds. The best way to play the trade war on the downside is through indirect exposure to China. The Chinese government will now use every tool available to stabilise the market: as such, thus investors should avoid shorting Chinese assets. Using indirect exposure via Japan, South Korea and/or other Asian asset classes (or even Europe, which is very sensitive to China) is a better way of expressing a negative view if the trade war escalates further.
South Korea at odds with calm markets
We highlighted South Korea as one of the key countries to watch for clues as to where the economy is headed. The Organisation for Economic Co-operation and Development’s leading indicators are suggesting a turnaround, which could turn out to be false, and Samsung has recently sounded upbeat on demand for memory chips. The country’s exports to China have also improved considerably over the past couple of months, but is it merely set to stabilise at low-growth levels? The currency is sending a worrying signal (as it has all year, oddly), but today's price action indicates that investors are not fully buying into the 'China stabilisation' narrative just yet.
Either South Korean equities and KRW are mis-pricing risk and macro, or everyone else in global equities (mainly US equities) are wrong in terms of direction. We argued last week that investors should profit or hedge risk as we believed that equities were discounting an overly positive near-term future.
South Korea at odds with calm markets
We highlighted South Korea as one of the key countries to watch for clues as to where the economy is headed. The Organisation for Economic Co-operation and Development’s leading indicators are suggesting a turnaround, which could turn out to be false, and Samsung has recently sounded upbeat on demand for memory chips. The country’s exports to China have also improved considerably over the past couple of months, but is it merely set to stabilise at low-growth levels? The currency is sending a worrying signal (as it has all year, oddly), but today's price action indicates that investors are not fully buying into the 'China stabilisation' narrative just yet.
Either South Korean equities and KRW are mis-pricing risk and macro, or everyone else in global equities (mainly US equities) are wrong in terms of direction. We argued last week that investors should profit or hedge risk as we believed that equities were discounting an overly positive near-term future.
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