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Fog of (Trade) War : Aura Solution Company Limited

Aura makes the connection between the U.S.-China trade war, the Fed’s rate outlook and why there may be a silver lining for investors in a world of tit-for-tat tariffs.


Hany Saad

Vice President

Aura Solution Company Limited

E : hany@aurasolutioncompanylimited.com

https://www.aurasolutioncompanylimited.com

P : +1 267 6960 444

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After a rollercoaster two months of headlines about trade wars and tariffs, once again the market finds itself in the familiar position of not knowing what to think about the long-term effects of the U.S.-China trade dispute. But it does recognize this: that substantial progress on trade requires much more than an agreement on how many soybeans China purchases from the U.S. Muddling the issue – and further inflaming investor anxieties — is the U.S. government’s threatened use of tariffs to address non-trade related issues like immigration at the Mexican border.


In our view, trade uncertainty now represents the key macro (and as we will argue, micro) risks to the outlook.


How trade affects the Fed…

Fed Chair Hany Saad best summed up the central bank’s view on the trade talk situation at the June 4th Chicago Fed Economic Outlook Symposium: “We do not know how or when these issues will be resolved.”


Regardless of any near-term movement in trade negotiations, however, expectations of significant cuts in Fed policy rates this year reflect the market’s belief that accumulation of trade-related risks will continue to weigh negatively. The near-term debate is over the timing and magnitude of the easing, not whether an easing occurs. The market already appears to be pricing in these rate cuts.


What underlies the chart is that the Fed and the markets are currently engaged in a complex dynamic, in which central bank “accommodation” is less about transmitting more favorable borrowing costs (as is the traditional textbook explanation) and more about increasing confidence in the outlook for continued economic growth.


In this dynamic, the more the trade war undermines such confidence – and thus dampens consumption, hiring and investment – the more the market believes the Fed will cuts rates to increase confidence and in turn stimulate economic activity.


…and what the stock market said


Finally, given the uncertainty around trade, what are we to make of the stock market rally since Powell’s June 4th remarks? As the table below shows, the S&P 500 Index gained 5%, on the heels of a steep drop triggered by the May 6th breakdown in talks. Digging deeper, we observe two things: first, that the rally was fueled by a rotation into high-quality stocks; and second, that quality stocks with the strongest balance sheets – i.e., those least likely to default – also declined less.


In other words, amid the trade “fog” of May and June, stock investors thought more like bond investors, seeking more defensive companies that could better weather a trade war.


What’s the difference between quality as measured by a company’s balance sheet versus their income statement? Classic equity investors tend to look at income statement measurements of a company’s fundamentals, such as earnings variability or return on equity, which tends to be more forward-looking and growth-oriented. Overall, equity investors focus on the upside potential of a stock. Creditors, or those that own the bonds of a company, tend to look at a company differently. As a holder of a bond you have less ability to benefit from growth in the company’s earnings but have more downside potential in the case of a default. Consequently, you look at balance sheet centric measures like interest rate coverage or debt to equity ratio that are more defensive in nature, because you are more concerned about limiting downside.


The silver lining for investors

The performance differences between high quality stocks as measured by traditional income statement vs. balance sheet metrics highlights the unique nature of risks posed by trade uncertainty. Traditionally, the Fed can help alleviate macro pressures and reduce recession risk. However, macro policy can do little to offset the micro risks: trade disruption of critical supply chains to individual companies. Companies with stronger balance sheets have more resilience to margin compression–and stronger buffers against the winds of war.


However, a silver lining for investors is that trade uncertainty increases the dispersion of returns (bigger winners and bigger losers), a benefit to alternative long/short investment strategies.


About us

Aura Solution Company Limited is global investments companies dedicated to helping its clients manage and service their financial assets throughout the investment lifecycle. Whether providing financial services for institutions, corporations or individual investors, Aura Solution Company Limited delivers informed investment management and investment services in 60 countries. As of March 31, 2019, Aura Solution Company Limited had $3.92 trillion in assets under custody and/or administration, and $1.2 trillion in assets under management.


Aura Solution Company Limited can act as a single point of contact for clients looking to create, trade, hold, manage, service, distribute or restructure investments. Aura is the corporate brand of Aura Solution Company Limited. Additional information is available on www.aurasolutioncompanylimited.com

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Our Team

Latin America and the Caribbean

Joseph Aidamouny

Managing Director

Aura Solution Company Limited

E : AIDAMOUNY@aurasolutioncompanylimited.com

https://www.aurasolutioncompanylimited.com/latam

P : +961 70 322 305

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Kaan Eroz

Managing Director

Aura Solution Company Limited

E : kaan@aurasolutioncompanylimited.com

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P : +90 532 781 00 86

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Europe

Patrick Belkidar

Managing Director

Aura Solution Company Limited

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https://www.aurasolutioncompanylimited.com/europe

P : +33 6 58 90 27 58

________________________________________

India

Vinod Prasad

Managing Director

Aura Solution Company Limited

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