Yes Virginia, There Is A Trade War

I continued my record of being an equity market contrary indicator by finishing my last piece with a deeply gloomy discussion of equities that was published hours before a top ten positive U.S. equity daily return close. The alleged logic that was pushed by some commentators was that the trade war was “paused.” (I lean towards the explanation that bear markets are violent — the top ten up days mainly occurred in major bear markets.) Since then, with tariffs between China and the U.S. on both sides over 100%, I think it is safe to say that the trade war is still on.

It is still too early for damage to supply chains to show up in economic data, so all we will hear are “anecdotal” reports of firms shutting down production, etc. The fastest moving data are Canadian cross-border traffic (-31.9% by auto, -13.5 by air in March), which is of interest to Canadians and U.S. border communities (which have negligible weight in the economy). However, the chill on international travel courtesy of random decisions by border agents may have long-term effects on international commerce. Nobody is going to put a new plant in a country if corporate brass cannot reliably visit the subsidiary. It is hard to quantify soft power (almost by definition), but its absence will eventually show up.

Long End Carnage

There is a great deal of speculation about the sell off in the long end of the Treasury market. There are reasons to be scared about an inflationary accident in the United States (e.g., massive tax cuts in the House budget package), so it is not hard to come up with a fundamentals-based explanation of the rise in yields.

The thing to keep in mind about the 30-year Treasury is that it is a niche security that is somewhat detached from the rest of fixed income complex. The ultra-long has a small capitalisation weight in the index (although it is important on a duration-weighted basis), and not many issuers have the credibility to extend their maturities out to 30 years. (Conventional mortgages have a amortisation period of 30 years, but their weighted average maturity is far shorter.) Since nobody can credibly forecast a quarterly path for the overnight rate for 30 years, rate expectations are a loose constraint on the 30-year yield. As a result, the long bond is at the mercy of the animal spirits of speculators and liability-matching investors.

Correspondingly, although the movements in the 30-year yield are an interesting way to make money, I think that enthusiasm for “what it means?” needs to be tamped down.

Trump Going After the Fed?

There is a lot of speculation that President Trump will attempt to take over the interest rate setting function of the Fed. Such an act is certainly something he has hinted at, and fits within his modus operandi of this term.

One thing acting in the Fed’s favour is that they have their own police force — Musk cannot just send in a handful of goons and take over defenceless buildings. (One possible post-Trump future is that every Federal agency will have its own paramilitary organisation to protect itself from the executive branch.¹) The other defence is that markets would “freak out” for at least a day or two, which might be enough to cause Trump to stay away.

Nevertheless, a takeover of some sort is possible. Based on past behaviour, it is likely that the American elites will roll over and accept the new state of affairs. To the extent that there is a revolt, it would be international investors getting out of U.S. dollar assets. The Fed has the capacity to absorb such selling, so the outcome may be less apocalyptic in price terms than fevered speculation suggests.

Manufacturing Employment

People who should know better are rushing to defend tariffs based on wacky theories about manufacturing. One common factor of the beliefs that manufacturing employment can rise as a percentage of the workforce in the United States is a complete unwillingness to listen to anyone who knows something about manufacturing.

Manufacturing employment has declined as a percentage of the total for three main reasons.

1. Since the end of World War II, there has been a major increase in the size and importance of engineering faculties. One of the core jobs of engineering and engineering research is to increase productivity of processes. We do not need the same number of workers to produce the same output.

2. Large manufacturing firms until the early 1980s tended to be conglomerates with a lot of internal services. The restructuring of the 1980s along with productivity improvements in services — e.g., firms no longer need pools of secretaries typing documents in headquarters — means that “internal services” employment was slashed. This means that the decline in “manufacturing employment” is not just line production employees, it is also people doing “service” work (which might be outsourced to new service firms).

3. Rising wages and work safety standards means that the bottom end of the value chain in manufacturing (e.g., high volume textile production) moved overseas.

Messing around with capital controls (a recent suggestion by Michael Pettis) is not going to change those engineering and organisational realities. The only path to increasing manufacturing employment significantly is reshoring sweatshops. However, who is going to work in those sweatshops? Until Trump rolled into the White House, the U.S. unemployment rate was bumping along close to some people’s estimates of NAIRU.

Weekend Reading

If current events are too depressing, I highly recommend reading Thucydides’ The Peloponnesian War. By looking at completely unrelated events in the distant past, we can forget about our own problems.

I read The Peloponnesian War a few decades ago, and my memory of it is hazy. (This article by “James” discusses the topic.) The history starts out with Athens leading the Delian League — an alliance of city states that was created to fight the Persians. The Athenians converted the league into a form of tribute-taking organisation as the Persian threat ebbed. Athens famously extorted Melos with the logic “The strong do what they must do, the weak accept what they must accept” (called the Melian Dialogue, which was required reading in any discussion of Realism in international relations). Athens ended up in a war with Sparta. Sparta was weaker, as it was crippled by its freakish proto-fascist government, and its unbalanced politics and political elites made it hard to make allies.

I would need to re-read the text to remember how well Athens did in the war.

1. “How many divisions does the HHS have?” may become a serious question.