Financial Weapons of Mass Destruction: Redefined

BY NICHOLAS RUBINO


In an interconnected global economy, no matter who wins the trade war, investors lose


In Berkshire Hathaway’s 2002 investor letter the ever wise Warren Buffet coined the term, “Financial Weapons of Mass Destruction” to describe the growing threat that derivatives posed to the economy. Six short years later the market for Mortgage Backed Securities imploded which started the crisis that nearly brought down the global financial world as we knew it. You don’t get the nickname “Oracle of Omaha” for nothing I suppose. Today the global economy faces a growing, if not so new, Financial Weapon of Mass Destruction in the form of economic sanctions. Economic sanctions have been a common tactic employed by world powers to exert their influence through financial pressure, and have most recently been used to promote the denuclearization of Iran and North Korea, to punish Russia for the annexation of Crimea, and to change the economic balance of power between China and the U.S.

The escalation of these sanctions has been a looming yet largely ignored threat to the nine year economic recovery that saw the S&P 500®  grow 333% from valley to peak. But now, as we stand on the precipice of a bear market, the true implications of the current “trade war” have been brought to the forefront. Case in point, on August 2, 2018 Apple became the world’s first trillion-dollar public company, but on January 3, 2019 Apple dropped over $70 billion dollars of value after the company announced that it was cutting its revenue guidance for the first quarter of 2019, specifically blaming an economic slowdown in China for weak iPhone revenue.

Coincidentally, on August 2nd the CBOE Volatility Index (VIX) closed at 12.19, a shockingly low measure of volatility and fear in the stock market compared to a close of 25.45 (109% increase) on January 3rd, 2019. The current U.S. administration’s trade war with China was a known risk in August, but an extended bull run and the use of fiscal stimulus (in the form of tax cuts) to cover up underlying economic frailties can make even the most practiced investors complacent.

Trade wars are defined as, “a side effect of protectionism that occurs when one country raises tariffs on another country’s imports in retaliation for Country B raising tariffs on Country A’s imports” by Investopedia. It is the “retaliation” that should scare investors most about the ongoing battle between the U.S and China. While pain is currently being felt by investors in both countries with China’s Shanghai Stock Exchange Composite Index (SSE) and the S&P 500®  (SPX) down 24.6% and 6.1%, respectively, in 2018 and broad economic indicators ticking down in both countries, we might not yet have seen the worst of the tariffs.

The first round of tariffs began on July 6, 2018 with the U.S. imposing a 25 percent tariff on $34 billion worth of Chinese goods and the Chinese imposing retaliatory tariffs on $34 billion worth of U.S. goods. Most recently, the U.S. and China agreed to a 90-day truce on December 2nd which postponed tariffs on an additional $200 billion worth of Chinese goods, and there have not yet been signs that the two parties will negotiate a permanent armistice.

Trade wars are won by the country that can tolerate the greatest amount of pain, and the bottom line is that there is no way to know who will surrender first or when that will happen. How far will these two world powers let the carnage go? Will bear markets in both countries’ leading stock indices suffice or will one or both countries’ economies need to enter a recession before each side comes to its senses? The only thing that is assured is that while the trade war is ongoing, investors will suffer.

Find asset classes that are uncorrelated to the stock market to hold while the war wages, and keep a bit of cash on the sideline to pounce on equities (both Chinese and U.S.) after the dust finally settles.

– Nick Rubino

Additional reading: Impact of economic sanctions on poverty and economic growth


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