US Will Win Most Trade Wars (But Lose in a Trade War With Mexico)

This post is inspired by the Trump administration's most recent moves on trade including the steel tariffs across many countries worldwide and the particular tariffs aimed at China. There's been a lot of discussion regarding these moves by the Trump administration on whether or not we will see global trade wars. Some of my regular readers may recall my old posts on how monetary expansion is basically a way for countries to start currency wars. In a sense, currency wars are trade wars. Using this line of reasoning, the Trump administration is not the one starting the trade war.

Anyways, it's important to note that out of the entire US economy, ~13% of US GDP is from exports. This makes the US one of the least reliant economies in terms of its need for external demand to sustain domestic demand. Also note that ~45-50% of that 13% of GDP in exports is within NAFTA. As long as NAFTA is held together, the impact of large-scale trade wars on the US economy is minimal.

If we account for all non-NAFTA exports, we reach a number that yields a total of ~6-7% of GDP. Note that much of that 6-7% is also in the non-NAFTA energy market (the largest net exporters of oil/energy to the US are Canada and Mexico). That means only ~5% of the US economy is actually exposed to large, rapid shifts in external demand if we exclude energy and if we go outside of the North American continent.

NAFTA:
What does all that mean? Firstly, it means NAFTA is so central and layered into the American economy that any large disturbance or removal of NAFTA could yield a major depression and create serious problems for Canada, the US, and Mexico. If such a scenario did occur, Canada would likely still have preferential access to US markets and would probably be mostly fine. Mexico, especially the parts of Mexico that've industrialized and seen the most foreign investment (mostly parts closer to the US), would get hammered. Canada won't be impacted much and could slightly gain (or lose) depending on how the NAFTA repeal played out.

Not only would Mexico be devastated, but the entire situation would likely cause fragmentation and a depression across large parts of the country as supply-chains fracture. The resulting impact would be very hard on US states near the Southern border--both economically and socio-politically. As a result, illegal immigration into the US from Mexico would likely rise as the rising Mexican living standards we've witnessed in the last ~15-20 years would suddenly fall apart giving migrants more of an incentive to come to the US. Drug cartels would likely gain more sway in Mexico, especially in areas further away from Mexico City (like near the US border).

NAFTA is so integrated into the economies of US and Mexico that discarding it would create real problems for both countries involved. Not only that, but it'd create a scenario where pretty much everyone in North America would be a loser. Hence, I'm highly skeptical of the Trump administration scrapping NAFTA.

Non-NAFTA:
The largest surplus countries/regions in the world are the Eurozone (concentrated in Northern Europe), Japan, China, Japan, and Asian Newly Industrialized Economies (NIEs; countries like Korea, Taiwan, Singapore among others). The main countries running current account surpluses are from Central or Northern Europe and the Far East.

Starting a trade war necessarily means that overall trade between the countries in question drops. So how can the US benefit much in a trade war if the overall trade between countries drops? The only way is by capturing a larger share of the trade balance.

Considering that the US doesn't export much to the rest of the world (especially if NAFTA is stripped out) and considering that the US has been far less protectionist than most of its competitors globally, a protectionist turn towards non-NAFTA members would lead to a significant rise in the US share of global exports. This would be very bad for most of the economies in the rest of the world, especially economies heavily reliant on exports to sustain their economic models.

Of course, the countries that won't be hurt very much are countries that don't rely on running current account surpluses to drive growth. What are these countries? For the most part, they're Anglo countries like the UK. You can add India, and probably Mexico (although in NAFTA), to that list of countries.

Conclusion:
In the situation NAFTA gets smashed, everyone in NAFTA loses (except maybe Canada, but even that is dubious). The best deterrence for Mexico and Central/South American migrants is if their countries are prosperous. Any policy shift that damages Mexico and Central/South American country economies will create serious problems for the US and such a shift would not be positive for the US. The ramifications and 2nd and 3rd order consequences of such a policy benefits no one. That said, I fully expect NAFTA will not be discarded.

In the case NAFTA remains and gets renegotiated, we will likely see the US trade balance improve and we will see the NAFTA countries current account balance improve relative to the non-NAFTA part. In this case, a trade war with pretty much any non-NAFTA country would lead to a benefit for the US. The primary countries that're threatened would be large surplus countries like Japan, China, Germany, Korea, much of Southeast Asia, much of Northern Europe, and some additional countries. Those countries' economies would be hammered in a global trade war where the US goes protectionist.

The countries least affected by a US lashing out at other countries protectionist policies would be countries with relatively liberal financial systems that run current account deficits like the UK and probably Mexico and India. 

Manias, Panics, Crashes, Market Structures, and a Different Model of Financial Markets

This post will demarcate the first in a series of posts about the general structure and behavior of financial markets. In the first post of the series, I'll discuss the general behavior of markets and their tendency to move in between extremes. This post will include the general use of leverage while emphasizing the role of both policymakers and the psychology of market actors, but will mainly be focused on market dynamics and how to construct a model of this world. This post will have 3 parts:
1. EMH and Basic Market Dynamics
2. Flip Between Bulls and Bears
3. Different Model of Financial Markets

1. EMH and Basic Market Dynamics
Before I begin with a basic idea of how financial markets operate, I'll first discuss an idea called the Efficient Markets Hypothesis (EMH). The general idea of EMH is that markets are correct ("efficient") in the way they operate. The idea also presumes market moves are uncorrelated, independent, and "truly random" (meaning it's not possible to predict direction or size of moves). EMH also assumes that market actors do not behave based on the behavior of other market actors, either directly or indirectly. In reality, none of these assumptions actually hold.

In reality, the behavior of market actors does correlate with the behavior of other market actors. Market moves also have some form of predictability in both predictability and size. In other words, market movements are not truly random and markets are not efficient. On the contrary, markets are often driven by what were called "animal spirits" by the great John Maynard Keynes. The underlying idea is that market fluctuations are driven largely by emotions, which overlook rationality.

In periods of exuberance and optimism, market actors can become oblivious to reality as expectations shift. Rising markets create the illusion of expectation of further gains in price, which result in more market actors buying. Over time, this becomes a positive feedback loop where more people buying creates rising prices which increase expectations resulting in more buyers and so forth. That structure is the underlying feedback loop in a bull market.

Also note that in bull markets, leverage often comes into play (this is more true for housing booms than for equity/stock bubbles, but it can be true for both). In the case of leverage, it will increase gains in asset booms and may even allow asset booms to last longer than they otherwise would. However, all of the gains that came in the boom will soon be wiped out in the subsequent bust while someone will run the risk of not getting paid back. That tipping point is called a financial crisis. In that period, we will usually see a panic and then a crash.

In the case of a bear market, all the same elements pushing markets up reverse. Prices fall and debts have to be paid. So panic selling appears. That places further pressure in falling prices. Leverage unwinds as firms fail. Liquidations begin to occur. Usually, a lender of last resort will come in to prevent total chaos for no reason, but everything else unwinds and you get a positive feedback loop as the economy goes into a downward spiral.

2. Flip Between Bulls to Bears
In the dynamics I laid out above, we can think of financial markets as having two different states: a low-volatility state ("bull market") and a high-volatility state ("bear market"). The vast majority of any cycle will be in the low-volatility state when things are going just fine and a positive feedback loop in asset prices is forming. In this state, there's not much volatility or fluctuation while asset markets tend to rise.

In low-volatility states, not only do asset prices rise, but leverage does too. As more and more market actors forget about the last crisis and more new participants enter who never witnessed the last crisis, the stable growth begets more growth. Expectations begin to slowly shift while policymakers actively shift policy to encourage growth after the crash. In this process, it becomes financially beneficial to lever up to buy assets because of expectations of future price gains.

However, leverage and psychology introduce financial factors that induce balance sheet fragility. Market participants, on the whole, end up seeing rising leverage, rising assets, and rising income from either assets being cashed out or from cash flow or for a "wealth effect" (or for many other reasons I'm not going to get into in this post). Eventually, the boom reaches the phase where many market participants rely on further gains in asset prices in order to sustain their ability to borrow and make payments on their liabilities rather than being able to make debt service payments from existing cash flows. Hence, asset valuations become more stretched as to dissuade long-term investors from participating or taking place.

As the low-volatility state progresses, long-term investors begin to slowly drop out of markets or behave like short-term speculators that act based on short-term indicators (like liquidity). If long-term investors drop out of a market, then the only way to entice them back into the market is for valuations to drop to a level wherein it makes sense for those who dropped out of the market to come back in. In other words, the only way to "stabilize" the underlying market becomes via a market correction.

So what happens when a crash is triggered: markets suddenly switch to a high-volatility state where fluctuations are large, where there's no large buyer/fundamental investor to come in when prices begin to fall precipitously, and wherein the psychology of market actors is focused on a very short-term time frame.

The flip between a low-volatility state to a high volatility state happens suddenly (often overnight) and the high-volatility state usually doesn't last very long. However, those high-volatility states contain the highest concentration of both upward moves and downward moves in a single day. They contain wild, rapid swings that don't get resolved until some event comes along that signifies either that long-term information is viable allowing long-term investors to re-enter the market or wherein a large enough correction in asset prices prompts investors to seek out profit opportunities that give them compensation for the risks they take.

3. New Model of Financial Markets (this is mathy, skip if you want):
The traditional model of financial markets assume the movement of securities prices are like that of Brownian motion (a "random walk") wherein every price movement occurs built on a distribution of a constant mean and constant variance. This model is a direct reflection of the EMH assumptions listed above. All of those assumptions necessarily imply that volatility should be a static variable.

In reality, however, volatility is not a static variable. It's a dynamic variable that's constantly changing. In mathematical terms, volatility is a stochastic variable, not a deterministic one. If volatility is a stochastic variable, then we need a model wherein it changes. Of course, I've built the assumptions of volatility as something that switches from two states (high volatility to low volatility).

The return will depend on the asset class, but I'll set this model up for stock prices. A play on a country's corporate business over a long-term time horizon is effectively a levered convex bet on NGDP growth. So the question is what to use as that leverage. I find ~1.5-2.5 as an appropriate long-term multiple growth factor. That's an overall number, but it may need to go up (~2-4) depending on the correction mechanism you use. You can even make that number stochastic if you want to, though it adds complexity that I'm not sure will improve model performance in practice.

Then, I'd use a valuation driven model that uses at least 80-90 yrs of data to determine the potential for correction dynamically. For my stock models, I use >100 year datasets and adjust them to account for more uncertainty, especially on the downside. Then, I take the long-term return, use a normal volatility average, add in some uncertainty, and add in a correction mechanism from the valuation based model. For the valuation based model addition, I prefer using bootstrap methods.

Note: I'm purposefully not going into detail in this model and am not being 100% rigorous cuz I'm here to give a vague, general description of something to follow. Many ways to adjust this model to your liking.