The 2018 World Cup has come and gone (congrats, France; condolences, England), and Game of Thrones remains on hiatus, leaving room for a new water cooler topic of choice: trade wars. The subject is no less thrilling or difficult to predict than either of the aforementioned forms of entertainment and boasts a similar or greater number of conspiracy theorists. And, managers and investors in all areas of the private markets are paying close attention. In fact, in our latest survey of more than 100 general partners from around the globe, trade wars topped the list of the reported biggest concerns for the world macro economy in 2018-20191. Any topic that engenders such market anxiety, not to mention such water cooler fodder, feels like something we should be weighing in on, so here’s our attempt to share the Hamilton Lane perspective on today’s hottest — or at least most hotly-debated — issue.
But first, a quick recap of where we are and how we got here. As he’s maintained since his days on the campaign trail, one of President Trump’s purported objectives has been to improve U.S. trade deals with other countries, based on his view that the existing trade frameworks are unfavorable to the United States. Initially, one of the tactics he employed was a threat of tariffs on selected goods coming into the U.S. from China, the EU and other countries. For the purposes of this discussion, let’s focus on the EU and China, as those are the U.S.’s two largest trading partners, as well as the areas of the largest escalation in recent months.
The topic is so fluid that, just recently, the U.S. and Europe appeared to reach an agreement in principal to avoid implementing tariffs on one another, following what had been months of back and forth deliberation that at times has bordered on antagonism. This quick resolution (assuming talks don’t reverse course) came as a bit of a surprise to almost everyone given the previously ominous tone of discourse. Perhaps the most feared scenario was that of a global trade war among a large number of countries. With the EU presumably off the table, that risk has been reduced — though most recently Turkey has imposed (and raised) tariffs on a variety of goods. But, for now, let’s turn our attention, as President Trump has done, to China.
The trade dispute with China, in particular, involves a host of other intertwined issues — the protection of intellectual property, foreign investment and M&A activity — that call into question the legitimacy of China’s economic integration with the rest of the world. It appears, however, that tariffs have become the blunt instrument with which to hammer out such concerns. In early July, after talks with China had effectively been breaking down over the preceding few months, President Trump implemented tariffs on $34 billion of imported goods. China promptly responded with an equivalent amount of tariffs on U.S. goods, and as of early August, Beijing warned it would match the Trump administration tit for tat should it move ahead with an additional round of tariffs on Chinese imports. In short, China appears to be shoring up its economy for a long trade conflict with the U.S. — a development that’s likely not the most welcome news for most businesses, investors or citizens of either country.
We now seem to have entered the strike/counter-strike phase, with each country threatening even more tariffs in response to the other’s actions. China initially zeroed in on agriculture, in a bid to target Trump voters in rural America. Then, in a move intended to counter the Chinese measure, Trump began providing government aid for U.S. farmers who are being hurt by the Chinese tariffs. Reaction to the move has been lukewarm, with skeptics arguing that farmers need certainty on trade, not governmental funding. Whether the dispute is promptly settled or escalates into an outright trade war is a matter of posturing, politics and economics with China.
It appears, however, that tariffs have become the blunt instrument with which to hammer out such concerns.
At the time of this writing, high-level trade talks between the two countries had stalled. No one knows exactly how this will play out, or what exactly the implications will be, given how broadly ranging are the potential outcomes. We will leave it to the economists to debate whether a trade war would be a positive or a negative for the U.S. economy, inflationary or deflationary for goods and services, or cause the Fed to change course on interest rates. (I’ve read passionate perspectives espousing each of those scenarios.)
Instead, we’ve endeavored to lay out what we do know, and what, in our view, private markets investors should be thinking about. Without further ado…
SIX FACTORS FOR INVESTORS TO CONSIDER DURING A TRADE WAR. (THAT IS, ASSUMING THERE IS ONE. WHICH THERE MIGHT NOT BE. BUT, IT COULD HAPPEN.):
- Currently, the tariffs imposed by the U.S., and threatened by other countries in retaliation, are relatively small in the grand scheme of the global economy. Unless the tariffs are expanded, they are likely to be painful for a small subset of directly-affected industries and companies, but the overall impact will be limited. That’s right — you made it this far only to find out that a potential trade war in fact likely won’t be very consequential for the private markets. But there are other factors to be considered…
- The overarching fear is that the dispute escalates and does so with unknown ramifications. The massive range of potential outcomes creates a tremendous amount of uncertainty, which may translate into volatility in the public markets. Our research team recently published an analysis of how volatility impacts public market and private market returns. The conclusion was that low- and medium-volatility environments had been good for public equity returns historically, but that high-volatility environments had not. Importantly, our research found that over long-term horizons, private equity continues to outperform other equity asset classes on an absolute and risk-adjusted basis (Chart 1).
2 Please refer to endnotes on page 4 for information on the indices used.
- Relative to the overall capital markets, private equity is weighted toward smaller companies. Smaller businesses tend to be more domestically oriented, with fewer overseas suppliers and customers. The asset class is also weighted most heavily to the U.S. and to service-based businesses rather than industrial businesses with integrated global supply chains and customer bases (think auto or electronics manufacturers). As a result, we believe private equity should be less affected than the public markets.
- Where, then, are private markets investors likely to feel the greatest impact? Two words: currency translation. Many of the trade war scenarios could involve countries attempting to devalue their respective currencies in order to drive export activity. If that occurs, the valuations of cross-border investments will rise and fall with the currencies. Private markets investors definitely need to be factoring this into their decision-making.
- Another area of consideration relates to the broader, intertwined issues of M&A and foreign investment — specifically, the impact on Silicon Valley VCs investing in China, as well as Chinese VCs investing in the U.S. Ultimately, this may end up being more consequential for the private markets than the tariffs themselves and, as such, is an area we will be watching closely.
- Finally, let’s not forget the overall private markets backdrop. Fundraising has been strong as a result of good performance and increased investor allocations to the asset class. Private market managers are sitting on fresh, undeployed capital, which is committed to them and can’t be redeemed if the outlook becomes cloudier and investors become worried. Compare this reality to that of the public markets, where a recent Invesco survey3 found that a third of sovereign investors plan to reduce their equities exposure in the coming years, citing trade war fears as a leading concern.
Patient capital provided by the private markets, along with an ability to do deep business diligence and create strong governance and alignment with management teams and investors, can prove a tremendous advantage in periods of dislocation. Should the economic environment change rapidly, or specific industries or companies undergo stress as a result of changing dynamics (trade wars or otherwise), private markets managers will be eager to capture the opportunity.
As of the publication of this paper, it has been reported that “low-level” trade talks are set to resume between the U.S. and China later in August. Depending upon the outcome of these talks, the concerns and factors being debated in this paper may be rendered largely moot. (See point #2 above.)
ENDNOTES1Hamilton Lane 2018 GP Dashboard
2Indices used: Hamilton Lane All Private Markets with volatility de-smoothed; Hamilton Lane All Private ex. Credit and Real Assets with volatility de-smoothed; S&P 500 Index; Russell 3000 index; MSCI World Index; HFRI Composite Index; Hamilton Lane Private Credit with volatility de-smoothed; Credit Suisse High Yield Index; Barclays Aggregate Bond Index; Hamilton Lane Private Real Estate with volatility de-smoothed; Hamilton Lane Private Real Assets with volatility de-smoothed; FTSE/NAREIT Equity REIT Index; S&P Global Infrastructure Index; MSCI World Energy Sector Index. Geometric mean returns in USD. Assumes risk free rate of 3.6% representing the average yield of the ten-year treasury over the last twenty years. (July 2018).
The Hamilton Lane All Private Equity Index tracks the performance of private equity strategies including buyout, venture capital, credit, and other special situation strategies. The index excludes real estate, fund-of-funds, and secondary fund-of-funds. The Russell 3000 Index tracks the equity performance of the 3,000 largest U.S. companies. The MSCI World Ex U.S. Index tracks large and midcap equity performance in developed market countries, excluding the U.S. The MSCI Emerging Markets Index tracks large and mid-cap equity performance in emerging market countries. The Barclays Aggregate Bond Index tracks the performance of U.S. investment grade bonds. The Credit Suisse High Yield Index tracks the performance of U.S. sub-investment-grade bonds. The FTSE/ NAREIT All Equity REIT Index tracks the performance of U.S. equity REITs. The S&P Global Infrastructure Index tracks the performance of 75 publicly-listed companies from around the world that represent the infrastructure industry. The HFRI Fund Weighted Composite Index is a global, equal-weighted index of over 2,000 single-manager funds that report to HFR Database. Constituent funds report monthly net of all fees performance in US Dollar and have a minimum of $50 Million under management or a twelve (12) month track record of active performance. The HFRI Fund Weighted Composite Index does not include Funds of Hedge Funds.
Desmoothing is a mathematical process to remove serial autocorrelation in the return stream of assets that experience infrequent appraisal pricing, such as private equity. Desmoothed returns may more accurately capture volatility than reported returns. The formula used here for desmoothing is:
rD(t) = (r(t) - r(t-1) * p) / (1- p)
rD(t) = the desmoothed return for period t
r(t) = the return for period t
p = the autocorrelation
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