Omega Point Blog

Impact of the Trade War in China

Omer Cedar

Impact of the Trade War in China

May 19, 2019

With all eyes on the US - China trade morass, our focus this week will be on seeing if we can empirically evaluate the impact that ongoing trade friction has had on Chinese stocks. We'll do so through the lens of the Exchange Rate Sensitivity factor in our China-specific model. Ultimately, we'll aim to find out if this factor is an effective way to track trade tensions, and to see how investors have been trading Chinese companies with exposure to it.

First, let's start with a review of the past week's market and factor action:

US Market (5/10/19 - 5/16/19)

Market+20190516

  • The market recovered mid-week after Monday's selloff stemming from China’s retaliation to the US administration raising tariffs to 25% (from 10%) on $200 billion of Chinese imports.
  • On Friday (not captured in above chart), the market bounced back from an early selloff on positive economic datapoints, only to end up closing lower as worries of a full-blown trade war persisted.
  • On the data front, the U Michigan's index saw consumer sentiment reach a 15-year high in May of 102.4, vs. the 97.1 consensus estimate.
  • The Conference Board's estimate of leading economic indicators rose for the third straight month in April.
  • Net global equity outflows over the past week hit $19.5 billion, while $5.1 billion flowed into bond funds.

Here's an update on how some key factors (and US Total Risk) have changed in the US model over the past week, using our normalized return indicator.

Factor+Table+20190516

Notes

  • Size factor continued its steep decline, falling squarely into Oversold territory at -1.48 standard deviations below the mean. Size recently peaked at +1.51 SD above the mean on 4/16, underscoring how rapidly normalized returns have deteriorated.
  • Momentum spiked +0.55 SD in the past week and has garnered the Overbought label at +1.12 SD above the mean.
  • Growth continued to gain ground in our normalized index, now sitting towards the high end of Neutral territory at +0.76 SD above the mean.
  • Volatility was slightly up on a normalized basis, while Market Sensitivity slowly drifted further into Oversold space.
  • US total risk (using the Russell 3000 as proxy) ticked up on May 13th to 14.08% and has since remained essentially flat at 13.98%.

Impact of the Trade War in China

Friday's news out of Chinese state media suggested that Beijing has little desire to resume negotiations after the Trump administration raised tariffs on Chinese imports, fomenting investor fears that a full-fledged trade war is in the offing. According to fund-flow data from the Institute of International Finance, this intensification of trade rhetoric has led to investors exiting Chinese equities at the fastest pace in over three years. This week, China’s CSI 300 index fell 2.2% and is now down 6.8% so far this month.

Today, we'll attempt to use the Exchange Rate Sensitivity factor to see if we can capture Chinese market movements around trade news. To do so, we created a portfolio that is long the highest net exporters and short the highest net importers in our China model (2,300 securities, ex-Hong Kong). In this case, Exchange Rate Sensitivity (ERS) is defined as 6 month beta to returns of currency basket containing USD, EUR, GBP, & JPY. Please reach out to me if you would like to receive the basket constituents.

Methodology:

  • We created an equal-weight Long/Short basket using the constituents of our China model.
  • On the Long side, we included all names in the model with > +1 z-score exposure to Exchange Rate Sensitivity (Net Exporters).
  • On the Short side, we included all names in the model with < -1 z-score exposure to Exchange Rate Sensitivity (Net Importers).

Exposure
Here's a snapshot of what this portfolio's exposure looked like on 5/16/19.

516+single+date+exposure

With a net 1.55 exposure, this portfolio does indeed represent the ERS factor in China. We can also see that it exhibits high Volatility and Liquidity characteristics, and has negative exposure to Short Term Momentum. This makes perfect sense as the exporter names have been selling off.


Here's the historical exposure chart for this portfolio from the beginning of Trump's presidency until now:

Exchange Rate Portfolio (China) - 1/20/17 - 5/16/19

historical+exposure+china+516

We see consistently high ERS exposure for this portfolio, hovering around 1.5 for the duration of this period. Volatility and Short Term Momentum seemed to have the highest variance within this time period, which is what we'd expect to see given the unpredictable swings inherent in the trade tensions.

Performance

By looking at total return for this basket, we can see how it has reacted to major events in the trade landscape over the past couple of years. Our assumption is that when trade war news is negative, investors will sell off the exporters and buy the importers. Conversely, we'd expect investors to overweight exporters over importers when they believe the trade war will be resolved. Let's see how this has played out since Trump's inauguration, with each number in the chart representing a news item that precipitated a sharp move in this portfolio.

performance+timeline+516
 
  1. April 2017 - Xi visits Trump at Mar-a-Lago and they set up a 100 Day Action Plan.
  2. May 2017 - US and China agree to a trade deal, giving US firms greater access to China’s agriculture, energy, and financial markets, while China can sell cooked poultry to the US.
  3. Nov 2017 - Trump visits China and strikes a warmer tone with Xi.
  4. Feb 2018 - US implements “Global Safeguard Tariffs,” including a 30 percent tariff on all solar panel imports and a 20 percent tariff on washing machine imports.
  5. Fall 2018 - US and China resume trade talks, Trump suggests he wants to fix things with China in order to avoid a prolonged trade war.
  6. May 2019 - Trade talks in Beijing stall out and Trump threatens to raise tariffs, eventually doing so.
Conclusions

Our assumption coming into this exercise was that companies with high Exchange Rate Sensitivity exposure will be more susceptible to major geopolitical risk events, particularly with regard to US and China. As it turns out, these securities really do move pretty intensely on the basis of trade news, as delineated by this factor. Next week, we'll take a look at a similar analysis for the US, since it's clear that tracking these trends can be helpful in picking stocks to buy and sell if you want to take a view on this trade war.

Regards,
Omer