By Chris Pedersen, CEO, Pedersen Asset Management
These are my views. I am not saying this will definitely happen.
I have been saying since Nov and Dec to lighten up on equities because of the chaos and uncertainties that will unfold come January from the US election. I have been explaining the negative impacts of tariffs.
It is all unfolding as expected.
The coming week: What now?
So, we now have last week’s wake up call. What about this week?
What I have observed is that large market drops occur when there are large unexpected negative events. We can model changes in interest rates. We cannot model impacts from a dangerous virus or from large amount of toxic debt where the amount is unknown (GFC).
I expect a huge fall in NY on Monday.
Why crashes often hit on Mondays
The reason these events happen Monday are due to investors (institutional and individual) using the weekend to digest news and determine how they are going to lighten their risk exposure to equities. Institutions are less reactive due to their reliance on performance relative to benchmarks. For example, if your benchmark index is down 15% and you are down 14%, the fund has outperformed. Accordingly, their need for large risk reduction is less.
A lot of investors lightening up just a little on the same day adds up to massive selling pressure.
Margin calls and forced selling
New York Friday night suffered a 5% drop. This causes margin calls. Interest earned on margin debit balances is a large profit centre for brokers. Thus, it is widely encouraged and utilised. The Federal Reserve and exchanges regulate broker margin. Brokers can be ruthless in forcing customers to satisfy the calls quickly since they take the principal risk to their own capital when clients become insolvent. Here in Australia, margin loans are nowhere nearly as extensively used.
On Monday in New York, there will be a lot of margin call selling. This selling can trigger more selling as prices decline.
In Australia, we have this one-day window today to make adjustments before NY opens tonight.
Tariffs: The great unknown
Trump tariffs are a huge unknown. We cannot predict if he will pull back or by how much. We cannot predict how much the retaliatory tariffs imposed by the countries against the US will be.
We do know this is all on US-focused trade. It does not impact Australian trade with our largest partners, such as China.
Why Australian markets still get rattled
Why do Australian markets tend to react as much or more to large US movements? Australian large-capitalised companies tend to have strong, low-debt balance sheets, decent profit growth, and overall are more conservative. We should be less volatile. My view is that the ASX does not have a market maker system in which participants act as buyers of equities during market drops, helping to smooth out spikes in prices both up and down.
1987: A case study in recovery
The crash of 1987 was short lived in the US due to the causes being addressed quickly (proposed changes in tax law on leveraged buy-outs). Plus, the Federal Reserve extended unlimited credit to market makers for them to confidently buy without risk of insolvency.
Where is it safe to park assets?
What are safe places to park assets? Bond funds and cash trusts. Property, not so much. Gold… I am not sure.
After a large market drop, it is usually pretty late to get defensive.
Could a relief rally follow?
In 1987, when the causes were able to be addressed, markets rallied. In Australia, the causes were different and more difficult to address. Thus, our recovery was slow. Trump could back down on scope of the tariffs. This would cause a relief rally.
My view is that Trump will not back down. However, he is often mercurial and contradicts himself in the same press conference. So, who knows. This is part of the problem.
All indications and pronouncements out of the White House are that they will maintain the current course. This is not good for global trade.
Trump’s negotiation style
There is a famous book from the 1980s by Herb Cohen called You Can Negotiate Anything. One important strategy throughout is that you are more successful if you pretend to “Care, but not that much”. Ie, the one who cares the most is the one who is at a disadvantage. Trump wants other countries to come begging to him and he is pretending to not care if the pain is unbearable.
I am sure this is behind his recent public announcements being blasé about markets dropping. Believe me, he cares. He measures his success against the stock market performance. It is also a benchmark he cannot claim is political or say is fake news. If he truly does not care, his Republican colleagues and their voting constituents care!
Tariffs and return on capital
Another view on tariffs is this: supporting an industry with lower profit margins by manufacturing in the US reduces a company’s return on capital. This lowers its stock price.
If US-made products are more expensive than similar foreign-made products bought overseas, the US will see a massive black market develop.
My history with major crashes
My experience with major market moves includes the 1987 crash, the Global Financial Crisis, and Covid.
The crash of 1987, when the market was opening, I received a call from the heir of a massive global pharmaceutical company, who asked my opinion. I told him to sell everything to preserve his wealth for another day. After the close, he called and said I was the only one who was right. Everyone said hold on. He lost close to $100 million. His margin calls killed him.
Next day I received two cases (24 bottles) of Dom Perignon, as thanks for being a resource.
GFC: Risk without visibility
During the 2008 Global Financial Crises, I was managing highly leveraged portfolios in a hedge fund type of investment program. I lightened up risk, not due to my foresight of the future, but because the market was not acting predictably. There were unknown risks in size and who owned what in the developing toxic debt story. This meant I could not model the risks. Investors lightened up on risk with no idea of how much should be sold or where to invest.
Covid: The unmodellable risk
With Covid, when word of the virus in China started to spread, I realised in early February that this was one of those unexpected risks, and the scope and duration were totally unpredictable. It helped that I had relatives in senior roles in NSW Health. We lightened up by hedging almost 100% to sit it out until more knowledge and ability to forecast consequences became available.
One thing that occurred after the massive sell-off was the huge stimulus by many government to keep their economies afloat. This caused an unanticipated rally.
Tariffs distort capitalism
Capitalism relies on growing your business, markets and profits. Tariffs force business into inefficient use of capital. This is self-destructive. Free markets create economies in dynamically changing environment to quickly adapt. The US is no longer a textile manufacture because companies found better use of investment capital in new products and services.
Profit over presence: Why US carmakers left Europe
US car manufactures voluntarily pulled out of Europe because the largest-selling cars were small and less profitable then making SUVs. To keep their profit margins and stock price up, they voluntarily exited the less-profitable European market. Can tariffs cause Europeans to suddenly want large US style cars? Of course not.
Will the French want to buy American cheese (artificially coloured orange) over their own cheese? In business, we cater to what the consumers want.
The power of the consumer
Think of colonialism: it was to grow markets. One aspect leading to the American Revolutionary War was England forcing the Colonies to buy English-manufactured goods over cheaper foreign-made goods.
The consumer wants to buy the cheapest product that is decent in quality they can find. Look at Walmart. Read the history of supermarkets. Consider airlines. Consumers buy the cheapest seats on-line. Airlines cut services to remain profitable. Poor airline food is not due to the airlines being cheap. It is because the consumer does not want to pay more.
US manufacturers did not move overseas because they wanted to. The US consumer demand for competitively priced goods forced manufactures overseas in search of lower labour and real estate costs. Think of Walmart again. With the massive deportation taking place in America now, where will manufacturers find the cheap labour domestically?
Trade deals take time
How can Trump change this global consumer trait overnight?
A Free Trade Agreement takes years to negotiate with large teams of experts. Now the US wants to renegotiate these agreements instantly and with over 50 different countries. This is an absurd time frame, and the US is massively under resourced to conduct such a huge undertaking in a short period of time. Besides, no one likes a gun held to their head.
The view around the world is that you cannot trust the US to uphold any agreement they negotiate and sign. Case in point, the revised North American Free Trade Agreement heralded by Trump as one of his crowning achievements in his first term. Five years later, it is deemed a disaster and ripped up.
