Things are starting to get interesting. The S&P 500 is down over 10% now from the mid-February peak and I am sure participants are getting a little skittish about asset pricing.
When things go crazy, it always helps to distill things to fundamental finance and economics and try to pick winners and losers.
One is that assets with higher risk are priced lower.
If your cash flows are 10, 10, 10, … to perpetuity, in a 10% rate environment, the asset will be worth 100. If the cash flows instead are 8, 12, 3, 17, -4, 16, etc., but still averaging 10, all things being equal that asset will be worth less than 100. One operational reason is that if a bank wanted to loan you money for your operation, there might be a chance you would blow a covenant. At the very least, you could take less leverage than the first “stable” operation.
Second, higher returns come from lower pricing.
Using the above example, if you managed to obtain the first asset at a price of 80 instead of 100, you would be sitting on a 12.5% return forever. If you bought it for 120, your return would be 8.3% instead.
Third is that a trade tariff is taxation.
Money that otherwise would go into the input is diverted to government. Governments, not known to being the most productive entities with capital, will likely reduce the overall efficiency of the economic engine.
Fourth – concepts of price elasticity
There are some items of trade that are crucial and have no substitutes. For these inelastic products, an increase in price will have no subsequent diminution in demand. Typically gasoline has been one of these products, but even then there is substitution effects with electric vehicles, or taking public transit, or just driving less. An even less elastic market would be basic food consumption – people need to eat to survive. The most elastic products would be semi-luxury products such as designer clothing and other completely discretionary purchases.
The seemingly “on again, off again” nature of the US administration has rapidly increased the perception of risk, hence lower prices (for financial assets). For price-elastic industries (which are most of them) this is going to have a marked decrease in overall demand due to increasing prices (of the consumable). As the aggregate demand drops, this will also have to corresponding boomerang impact of suppressing prices and create a negatively reinforcing loop. Despite revenues and profits decreasing, the amount of leverage employed to support decreasing profitability will result in a deleveraging shift.
Essentially this might be the start of the unwinding until central banks decide to employ the “plunge protection team” when opening up the monetary spigots once again. We are nowhere close to the conditions where the central banks will go full-blown QE, but you can be sure they are watching in regards to the stability of the financial system if we start hearing rumours of firms going under.
In Canada, we have the short-term rate likely to drop to 2.5% on their April 16 policy meeting. The yield curve has been a shallow “U” shape for some time, a change from the persistent inversion seen a couple years back. However, the introduction of quantitative easing is slowly back on the radar, both in Canada and in the USA – Canada has stopped their tightening, while the USA has slowed down theirs. This has been more gracefully implemented than what happened in 2009 and 2020.
Unlike what happened with Covid-19, I do not have a good radar as to where the opportunity is. I still continue to remain very defensively positioned with a high magnitude of cash, but many of my selections that I have taken small positions I have faced losses with.
The timing is going to be tricky. In bear markets, the bull rallies are usually quite monstrous in magnitude but very short-lived. Valuation-wise, we still have a lot of the S&P 100 in nosebleed territory and the perpetual EPS growth estimates are likely going to be tapered down significantly, which completely busts the rationale for high P/E valuations.
If I am using the year 2000 playbook, this has yet to still play out on the downside. There will be sharp rallies luring participants back in, thinking the worst is over. Cash is a defense – out of all the stupid decisions I made over the past couple years, I do not regret this one.
Reigniting inflation via trade war in already high interest rate environment – what could go wrong?
IMHO, stagflation is a more probable risk right now, so I guess we need to brush dust from 1970s playbook?