Tail Risks: Trade War

Tail risks for August – the monthly Merrill Lynch fund manager survey is out. As you can see from the chart below, the August risks have changed from July. The risk of a trade war is about the same. This makes sense because there hasn’t been a resolution nor an escalation to the point where it affects the economy in a substantial way.

We seem to be at the edge of the proverbial cliff where in a few months the trade skirmish will either become a real trade war or there will be a resolution. Personally, I think neither option will happen in the near term because politicians love to kick the can down the road.

President Trump certainly has no reason to give in because the American economy is doing well. China is doing poorly, but the tariffs are too small to be the main reason why it is floundering.

Trump could be considering issuing a major tariff to force China to act because China is already in bad shape. However, it will hurt him politically if China doesn’t give in right away. Therefore, he might be waiting for its economy weaken further before trying this tactic.

Tail Risks: QT

The two new risks listed in August are quantitative tightening and a China slowdown. The quantitative tightening has been ongoing since October in America. However, I think it’s better to look at all three major central banks’ balance sheets. As you can see, the year over year increase in their assets has declined sharply from late 2016.

The Fed has unwound part of its balance sheet and the ECB has tapered its buying. The ECB’s purchases will end in December. The American economy has done fine during this period. You would think it would be hurt the most since its central bank is pulling back the most.

You can make the case that the decline in the growth of the major central banks’ balance sheets is causing emerging market weakness, but I don’t like to follow the train of thought which blames everything that has gone wrong on QE.