US equities have become increasingly volatile amid US-China trade tensions and the S&P 500 has actually delivered a near-flat return since January 2018. Markets have become very headline-driven, portraying immense sensitivity to even Tweets by the US President. This has led to recurrences of irrational behavior where markets tend to rally on even the slightest ‘positive’ trade developments, even when there has been no meaningful progress, and computer programs are playing a vital role in these events.

Have recent positive developments really been meaningful for the economy?

Let's take the recent development as an example; equities rallied strongly on the news that China is open to a partial trade deal. However, digging deeper into the news revealed that their requirements are unlikely to be accepted by the Trump administration. All China is willing to offer is buying more agricultural products, for which in return they want to eradicate further tariffs. They are certainly not willing to make any concessions on the more difficult negotiating-points, such as industrial reforms. President Trump will want to avoid losing face by any means prior to the 2020 elections, hence will likely push China for more concessions as opposed to settling for more agricultural purchases. In fact, even when Trump has agreed not to raise more tariffs, it has not lasted long before he goes ahead and charges additional duties on Chinese goods. Therefore, such headlines and developments are quite meaningless with regards to the economic outlook. Therefore, it makes little sense for markets to rally strongly on such events.

Furthermore, another major factor that has been driving equity prices is the easing monetary policy stance of the Fed. The central bank has already cut rates twice this year, with at least one more expected this year. Though recent Fed minutes revealed that even Fed officials believe the markets are going too far with their rate cut expectations, and thus the market is clearly setting itself up for potential disappointment ahead. Moreover, amid the recent repo market turmoil, Fed chair Powell stated that the Fed would restart purchases of Treasuries to improve liquidity conditions and thereby better control the effective fed funds rate to keep it within the target range. This headline also induced markets to rally higher. While easier monetary policy is certainly helpful amid deteriorating global growth conditions, to what extent can lower interest really be effective at encouraging corporations to engage in capital expenditure when trade conditions are only getting worse? Cheaper borrowing costs are certainly not a magic fix to rising tariff bills for US companies. Hence the fact that the market still rallies strongly in reaction to such headlines seems irrational.

The role of algorithms

Human investors and traders are wise enough to comprehend that mere positive trade headlines are unlikely to bring meaningful change to the economic outlook and that a dovish Fed is certainly insufficient to counteract surging tariffs and deteriorating trade conditions. On the other hand, computer programs/ algorithms are programmed as such that they are instructed to buy or sell equities if certain keywords/phrases appear in headlines/ tweets by the US President. Hence for instance, the recent headline phrase “China Open to Small Trade Deal” automatically triggers “buy” instructions, even though there is no meaningful change in the underlying fundamentals. Thus such irrational spikes in stock prices leads to unjustified valuation expansion, making stocks more expensive. And the influence of such computer-driven trades should not be underestimated, given that “according to Deutsche Bank, 90% of equity-futures trades and 80% of cash-equity trades are executed by algorithms without any human input”.

There are various reasons why a significant number of fund managers are employing computer-driven/ algorithmic trading strategies, including cheaper and faster execution. Though one of the main advantages involves the use of Artificial Intelligence (AI) to gain an edge in “factor” investing, whereby “AI-driven algorithmic investing often identifies factors that humans have not”, giving Quant hedge funds an edge over other non-Quant investors. Admittedly, AI and machine learning technology does offer lucrative opportunities for institutional investors.

However, it is important to remember that computers are not flawlessly perfect. For instance, humans like President Trump (or any politician in general) could put out a lie regarding the progress of US-China trade talks, which computers may not be able to pick up the way we humans would. Humans know better than naively believing a mere positive headline regarding the US-China trade war, given the number of times such optimism has turned out be false and short-lasting. However, this does not stop computers from pricing the headline into stock prices, which leads to mis-pricing of securities.

Eventually one day AI could better understand the credibility of such headlines through deep learning techniques based on historical data, but presently they do not appear smarter than humans at picking up untrustworthy headlines given the irrational rallies we have witnessed following even the slightest bits of positive developments that may not be significant at all.

Therefore, this irrational behavior could induce a bigger downturn at some point down the line as those apparent ‘positive’ headlines are not reflected in company earnings; leading to stretched valuations amid declining earnings and thereby making the market more sensitive to a downturn. In fact, even amid the volatility, the market is still expensive with a P/E ratio of 20.26 (at the time of writing), and thus investors should tread cautiously.

Bottom Line

Trade relations between the world’s two largest economies are only getting worse, and given how long this trade war has been dragging on for, naively expecting a comprehensive trade resolution in the near future is just irrational. Given the heightened market volatility and sensitivity to trade headlines, it is not advisable for investors to hold significant exposure to the equity market. Additionally, computer algorithms are only making market conditions worse as equity rallies based on meaningless headlines lead to unjustified valuation expansions, magnifying the risks for a severe downturn in the future, as stocks may not necessarily have priced in deteriorating corporate fundamentals and earnings by the time they materialize (due to misleading positive headlines). This is a market investors should stay away from.