Where we are:

• We are in year 15 of a trade war, one that began very slowly and invisibly, but which was brought into the open in 2016.
• We had spent 40 years increasing efficiency at the expense of robustness. This has changed in recent times.
• Inequality between countries has receded but inequality within countries has risen. This enables and drives some of the political and social dynamics we experience.
• Inequality has encouraged over saving and led to complacency in sovereign funding.
• We’ve had 80 years of American provision of security and economic and political leadership. This appears to be coming to an end.

Where are we headed?

• Will the current escalation mark a zenith or merely an inflexion point?
• Will the war stay in trade, or will it spill over to other domains?
• Substituting robustness for efficiency is naturally inflationary, and possibly stagflationary.
• Sovereign debt ratios have risen. Covid was a single event that raised fiscal deficits, but current trajectories don’t seem to signal a mean reversion.
• Life expectancies are rising. This has implications for dependency ratios, fiscal deficits, social dynamics, personal finance.

What does this imply?

• Sovereign credit is often manifested in FX.

  • Europe, China and India have room to spend.
  • US and Japan do not have room to spend.

• Geopolitics. It depends.

  • Hostilities escalate.

    • This would always be unpredictable, but some things will be unavoidable. Expenditure on unproductive assets such as military materiel will be inflationary. Economic growth could actually accelerate if industrial war machines are engaged. Post conflict resolution, technology might actually receive a boost.

  • Hostilities abate.

    • This would be the base case envisaged here. The developed world is getting too old and rich to spoil for a fight. Still, accidents can happen.

• Savings rates.

  • Fiscal and monetary policy may tend to be progressive and lead to an aggregate reduction in savings rates. Fiscal deficits may be more persistent or rise while monetary policy is more constrained.
  • Equilibrium interest rates could rise. 

Navigating markets:

Some themes will play out over decades. However, they are path dependent and initial or near term conditions will impact trajectories.

Artificial intelligence.

The quest for AGI is unlikely to be successful, however, tangential development will be sufficient to drive a lot of innovation and productivity. There will be some significant disruption to labour markets, not from a simple displacement but expect AI to shuffle the deck. AI’s energy thirst will drive renewable energy demand until more efficient compute is engineered. Invest in renewable energy or in more efficient computing. Consider the entire ecosystems around these themes.

Longevity.

Healthcare access and cost will need to be addressed. Some countries are close to the point of a healthcare crisis.

Labour demand and supply will need to be addressed. For many countries, labour mobility and immigration will be unavoidable and should be facilitated.

There will be implications for the savings and investment industry which will need to present public and private solutions to funding post-retirement life.

Inflation.

Interest rates are likely to rise in the longer run. Ageing populations, rising fiscal deficits, lower savings rates, constraints on monetary policy, combine to tip the balance in favour of rising interest rates, and debt service. Interest rates are one of the most important factors in asset valuations so that an opinion on the trajectory of rates will be unavoidable.

Planetary heating.

One significant contributing factor to solving planetary heating is the free rider problem. Solutions will therefore require internationally coordinated regulation. In a deglobalizing world, this will be challenging. Fortunately, renewable energy is already mostly cheaper than fossil fuels. Non-financial barriers to adoption remain, keeping capacity factors lower than they need be.

If one believes that one will be paid for solutions, then investment in decarbonisation and renewables is likely to pay off despite the current volatility in carbon markets and the uncertainty around policy support for environmental investments.

The USD and US financial hegemony.

For over 80 years the US has provided the world with a public good: the USD and a rules-based free market financial system. In return the US enjoys cheap funding and political and economic influence divorced from the health of its economy. The current US administration appears unwilling to continue to provide this support. The price is that the USD and USD interest rates will become dependent on economic fundamentals. What this means in practical terms is that fiscal indiscipline will result in credit deterioration which will manifest in both interest and exchange rates. A weak USD is not a given but will depend on the fundamental health of the US sovereign balance sheet. Higher interest rates are not a given but will depend on whether the US can manage both prudent fiscal management as well as price stability. While Trump dominates the news, we need to look beyond this Presidential term and consider the durability of his politics and policies, the individuals that might succeed him, and most of all, the integrity of the executive, legislative and judicial pillars of government.

In times of unruly markets, even long short, hedged or market neutral portfolios can behave in unexpected ways. This may be because of factor biases or technical reasons.

Factor biases are the most obvious reason for unexpected behaviour. If you’re net long or short a sector, size, valuation, country, or cyclical v defensive factor, your portfolio is not robust against rotation.

What’s not so obvious is that a properly hedged or balanced portfolio can still misbehave. Technical factors may be responsible.

Crowding. If the market is long some names and short others, this creates instability. Now the market is always in balance so what do we mean by the market being long or short? We refer to the length of the dynamic, actively managed portfolios. Long term, passive investors don’t contribute to this type of volatility. When markets fall, sometimes, hedge fund deleveraging can lead to crowded longs being sold and crowded shorts being covered (bought). This makes the longs fall faster than the shorts, which, incidentally, may even rise. Crowding is sometimes a sign of groupthink and a lack of imagination. I

Too much leverage. When a portfolio is too leveraged, a small loss at gross asset level can lead to a big loss at net asset level which can trigger margin calls. Here the trigger puller is not the investor but the provider of leverage. When the gross leverage rises due to an erosion of the NAV, your prime broker may ask that you reduce your longs and shorts.

Leverage and liquidity. Your broker will mark your longs to the bid and shorts to the offer. When markets get unruly and bid offer spreads widen, the portfolio NAV can shrink even if mid prices haven’t moved much. Now consider what happens when you have large gross exposures. The NAV shrinkage increases the leverage and triggers margin calls.

An over leveraged prime broker. This is unlikely to happen these days with Basel 3 and additional capital requirements but never say never. Through no fault of your own, because some other client has overcooked their book, a prime broker facing financial stress can require you to deleverage.

When markets get weird, there is no better way to stabilise your portfolio than to reduce exposure on both longs and shorts. Correlations can change quickly, dependencies can arise, or evaporate.

Well hedged long short, hedged or market neutral portfolios are very well in theory but may not work in practice when markets get gappy.

The US economy a year ago was experiencing strong growth from the momentum of a fiscal impulse as well as expectations of rate cuts, of which we got 3 beginning in July. Did the US economy need rate cuts? Probably not on the strength of coincident data at the time. But from the perspective of refinancing corporate debt, which would extend the impact of the rate hikes of 2022/23, the economy probably did need them. By early 2025 it was clear that while inflation was moderating, it was not falling to pre-COVID levels. At the same time, growth indicators were beginning to slow, if modestly. For the US economy to maintain its growth trajectory, the Fed would have had to thread a fine line of well-timed and sized rate cuts through 2025 and beyond.

The trade war initiated by President Trump has changed the landscape for the Fed. Tariffs are inflationary but the impact is likely to be an initial sharp step up. Thereafter, things are less clear. If the economy slows, as one might reasonably expect, inflation pressures will ease. On the other hand, a new trade equilibrium exacerbated by potential labour shortages, tariff escalations and supply chain disruptions is likely to be inflationary. The net impact on inflation is hard to guess.

The impact on output is a bit clearer. Consumer confidence will be further impaired and consumption is 67% of GDP. Investment, 18% of GDP, will likely fall sharply as corporate investment plans are halted by uncertainty. The 18% of government spending will likely be constrained by the already increasing fiscal deficit, compounded by rising funding costs unless rates are cut aggressively and the yield curve is cooperative and doesn’t steepen sharply. The current account deficit will probably shrink sharply as trade shuts down.

On balance, the odds are that inflation remains elevated while output slows and probably shrinks. The thankless job of monetary policy would encourage rational Fed officials to find other vocations.

Economic forecasting is difficult enough when geopolitics is a continuous diffusion. When it is a series of discontinuous changes in direction or pace, forecasting is impossible. One has to get the geopolitical outlook right before one can make inferences about the economic impacts.

Trump intends to achieve net zero trade balances on a pairwise basis with all trading partners. Is this useful? That’s not the relevant question. Is it practical? Also not very relevant. Will he go for it? Very relevant. Answer? Don’t know. Best guess, he will go for it.

Much depends on the response of the various trading partners. If they retaliate then one can expect Trump to escalate. If they back down and negotiate, the risk of non-tariff conditions rears its head. The US believes itself capable of self-sufficiency and with the development of fracking and shale oil, they nearly are. Nearly, because they still need immigrants.

One can only hope that trading partners choose not to escalate. Too late; China has called (+34%) and Trump has raised (+50%). A less ambitious hope is that America’s trading partners at least do not turn on one another and decide to restore some normalcy to global ex-US trade. There are some signs of this. The EU has refrained from tariffs on bourbon, wine and dairy products and has reached out to China to coordinate the management of trade diversions resulting from the American tariffs. Still more needs to be done to prune tariffs and non-tariff barriers to trade. The business lobby in the US will be a significant actor. This constituency had cosied up to Trump during his campaign and pre Liberation Day in an effort to either gain favour or influence policy. That strategy has not paid off. With global supply chains as integrated as they were, US business has every interest in lobbying for some tariff relief and orderly industrial policy. Until they succeed, corporate investment, almost a fifth of US output, will be on hold.

It is now time for the world to generally cut tariffs in response to America raising tariffs.

Tariffs are analogous to punishing one’s kids for preferring the neighbour’s cooking. The tariff nation’s population pays.

Tariffs are the cost of accessing the US consumer. The world has been too reliant on the US consumer. Time to find other sources of custom. Balance is healthy.

Trump may claim victory if one cuts tariffs which might mitigate some of the short term pain of a tariff war. He may cut tariffs in response to tariff cuts by America’s trading partners. They should not capitulate. They should impose export taxes on goods destined for America at rates equal to the tariffs proposed 2 Apr 2025.

America seeks a new world order based on areas of influence. It has no time, interest or resources to deal with the Asian and European timezones. It seeks a pragmatic solution to the political and economic problems in those timezones. America’s area of influence is geographically defined and is latitudinally expansionist.

The Asian timezone will likely be dominated by China. India is a second possibility although its ambitions may be more domestic and commercial whereas China seeks a more expansionist and holistic approach. America appears to accept a regional hegemon to deal with.

Europe is harder to predict. America seems to countenance Russian influence in the region. Again America may accept a regional hegemon to deal with although its hard to see Russia being the choice. The European Union is too messy to deal with efficiently or as a single bloc.

Economically and commercially, a potential development is the reorganization of supply chains latitudinally within the American, Asian and European timezones with each bloc then transacting with the others via their regional hegemons.

What does this mean for markets?
How will the regional hegemons maintain compliance?
How will the regional hegemons transact with one another?