Adapting to Uncertain Market Conditions
One key attribute that characterizes an adept trader is the ability to adapt to different market conditions:
- An adept trader has different strategies on hand for uptrending, downtrending, and non-trending markets.
- An adept trader has a good sense as to which market conditions to engage and which to avoid.
- Most importantly, an adept trader has enough wisdom and experience to consider at least more than one potential outcome; crafting a strategy to exploit the opportunities and mitigate the risks that each potential outcome presents.
As traders willingly engage in uncertainty, considering that “speculation” is by its very nature a pursuit of an estimated outcome yet unseen, a trader’s craft is geared not toward predicting future outcomes but toward asserting a reasonable framework that may lend shape to uncertain events, making the potential “chaos” of certain events actionable.
Making a Potential Trade War “Tradeable”
Over the last four months, the markets in general have been reacting in a volatile manner to a number of fundamental and geopolitical scenarios, one being the Trump tariffs and the possibility of a trade war.
The potential outcomes—i.e. the actions and reactions that may come from both sides—will vary. Possible outcomes might range from tepidly unfavorable to highly unfavorable; the worst being all-out global economic warfare. As a trader, perhaps the wise thing to do is to analyze the potential outcomes and to strategize different ways of trading (or not trading) them.
But how do you break down the consequences of a trade war into different phases? A few months ago, Goldman Sachs published a four-scenario simulation of trade war levels that progress in terms of severity. You might want to consider this outline as a set of possibilities from which to strategically determine possible trading responses (including, of course, a refrain from trading at all).
Four Scenarios of a Trade War
According to the Goldman study, there are 4 consequences that can materialize, enumerated according to level of severity:
Scenario 1: There may be no major retaliation or escalation in response to US tariffs: the announced tariffs will cover around 1% of US imports. Interest rates and exchange rates will respond accordingly, but overall, equity prices will most likely remain stable.
- The positive effect of the tariffs on the US real GDP will be small: possibly only 0.01% stronger after year one with core inflation rising by 2 basis points.
- The tariffs will boost domestic production, giving slight rise to GDP.
- This growth may lead to higher interest rates, countering the effect of higher inflation while boosting the dollar.
Scenario 2: A trade war breaks out, the US its main focus: Retaliation from trading partners prompts the US to further increase its tariff rates.
- US exports are significantly hampered by foreign tariffs.
- As compared with the baseline prior to the tariffs, the inflation rate rises even higher.
- The Federal Reserve may hike rates faster in response, strengthening the dollar even more.
- Foreign tariffs against US exports may help cushion the impact of US tariffs, but higher interest rates lead to slower growth.
- Overall, a tariff rate at or below 5% among the US and its partners may still yield a small impact.
Scenario 3: A global trade war breaks out: In this scenario, each nation decides to impose a 5% tariff on every other nation.
- The impact of global protectionism becomes severe as global inflation depresses consumer spending.
- Nations with trade surpluses, such as those in Europe, will take the brunt of the impact.
- Central banks are forced to raise interest rates.
- In this scenario, the US dollar will no longer strengthen.
Scenario 4: Global trade war sparks an equity sell-off across the globe: Equity markets across the globe plunge by 10% in response to a 5% global tariff rate.
- Markets across the globe will respond adversely to the global trade war.
- The US and other nations with large equity markets will be impacted the most.
- The US dollar weakens significantly.
In Conclusion
Crafting a strategy to trade these scenarios is up to you. What we provided above is the general framework. Bear in mind that if any of the scenarios above are triggered, they still may unfold in ways that differ from the Goldman simulation. After all, markets, economics, and geopolitics comprise a highly dynamic field of actions and events. Any strategies based on potential outcomes should always be flexible enough to accommodate change.
There is a substantial risk of loss in trading futures, options and forex. Past performance is not necessarily indicative of future results.