Tariffs, International Trade and Game Theory

 

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If you were in charge…

If you oversaw your own country, what trade policy would you pursue?  Would you be friendly and cooperative or unfriendly and betraying?  Maximizing your country’s payoff may be more difficult than imagined.  Game theory can be used to measure success and failure.  It can also validate just how hard it can be to strike the right balance and allow both trade partners to win.

 

The prisoner’s dilemma…

The current trade and tariff dialogue between the U.S. and China is essentially a repeated prisoner’s dilemma – a workhorse model of game theory that captures the tradeoff between mutually beneficial cooperation and individually beneficial betrayal[1]. If played once, there is only one outcome where neither side can do better with a different strategy: both sides betray one another.  While unfriendly, the mutual betrayal results in equilibrium or balance.  The shortfall of playing one time as if there is no tomorrow, is that trading partners have an infinite number of days in which to trade goods.

If prisoner’s dilemma is played multiple times, even infinitely, game theory tells us that mutual cooperation is best, but reaching the perfect equilibrium is very difficult.  If a country doesn’t play nice by threatening to impose tariffs (the U.S.), another country could punish it with reciprocating tariffs (China).    Countries like China and other developing nations have what many in the U.S. believe are protectionist policies – higher tariffs, bans on certain imports & government supported industry – that hurt the U.S and other trading partners.  In game theory, these practices could be interpreted as betrayal.  However, international trade and cooperation is not that clear cut and striking the right balance requires nuance difficult to replicate in a simple game.

 

State of the economy…

Recent market volatility has been unsettling.  The technology sector, a driver of 2017 market returns, saw 1st quarter declines prompted by data privacy concerns and the potential for increased government regulation.  Inflation and future interest rate increases remain at the forefront of Federal Reserve discussions.  Tariffs and subsequent trade wars threaten to undermine the relatively cooperative equilibrium between the U.S., China and other trade partners.

More positively, consumers seem to be benefitting from tax reform and showing increased confidence in the economy.  Corporations are increasing capital expenditures and earnings have been strong.  Federal Reserve monetary policy is not yet restrictive, and the broader economic outlook remains solid.

 

Because markets remain volatile, a reminder of portfolio changes…

Over the past twelve months, steps have been taken to reposition portfolios to better respond to increased volatility and market declines.  These include:

  • March ’17 – 1% US Mid-Cap and 1% Developed International to CS Managed Futures (equity to hybrid shift).
  • September ’17 – iShares Core S&P Mid-Cap ETF to Scout Mid-Cap (passive to active shift)
  • October ’17 – Adirondack Small Cap to PowerShares S&P Small Cap Low Volatility (in anticipation of increased volatility)
  • February ’18 – U.S. Aggregate Bond ETF (intermediate maturity) shift to Investment Grade Floating Rate Bond ETF (short maturity) and Nuveen Inflation Protected Municipal Bond Fund (both in anticipation of increasing inflation and interest rates)

 

Time will tell whether these changes have a longer term, positive impact on portfolios.  Over the past few months, we think they are performing as expected by reducing volatility and slowing declines. Remember the market is unpredictable, will have hiccups and more may be on the way.  We believe the overall state of the economy is still good, but we will remain attentive to the recent tariff rhetoric, broader economic trends and any resulting impact to the global economy.  In the meantime, try to remain focused on the long-term.  In our opinion, a diversified portfolio continues to be the best way to achieve your long-term investment goals.

[1] We Let Our Readers Practice International Trade.  They Started A Bunch of Trade Wars. April 3, 2018; FiveThirtyEight.com