Pairs Trading on Tariffs

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The upcoming tariffs on Chinese goods have created significant shifts in the US public markets. Today, we're exploring how these changes present unique opportunities for a specific trading strategy: pairs trading.

Pairs trading is a market-neutral strategy that profits from the temporary divergence of two historically correlated assets. This writeup will explore how new tariffs on Chinese goods might impact US companies and sectors, creating opportunities for pairs trading. We will also discuss how to identify potential pairs and hedge against risks in this volatile environment.

Pairs Trading Strategy in the US Public Market Amid New Tariffs on China

The implementation of new tariffs on Chinese goods presents both challenges and opportunities for investors in the US public market. While some sectors may suffer, others stand to benefit from reduced competition and increased domestic demand^1. This dynamic creates a unique environment for implementing pairs trading strategies, a statistical arbitrage technique that capitalizes on the temporary divergence of historically correlated stock pairs. This article explores the potential of pairs trading in the current economic climate, exploring the impact of tariffs on specific sectors and identifying potential pairs that could yield significant returns.

Impact of New Tariffs on China on US Companies and Sectors

New tariffs on China will have a multifaceted impact on US companies and sectors. The tariffs are not just about consumer prices; they also impact firm profits, investment decisions, and employment, ultimately trickling down to the overall economy² . In addition to potentially increasing inflation, these tariffs can disrupt global supply chains, creating chaos for businesses that rely on imports³ . While some industries may face increased costs and reduced profitability, others may experience a surge in demand and market share due to reduced competition from Chinese imports¹ . It's also important to consider that China may respond to these tariffs with its own protectionist measures, potentially escalating the trade war⁴ .

Sectors and Products Affected by Tariffs

The new tariffs specifically target a range of products and industries, including:

• Electric vehicles: Tariffs on Chinese-made electric vehicles will increase, potentially impacting US automakers that rely on imported components⁵ .

• Batteries and critical minerals: Tariffs on batteries and critical minerals used in electric vehicles and other technologies will also increase⁵ .

• Semiconductors: The semiconductor industry, crucial for various technologies, will face higher tariffs on Chinese imports⁵ .

• Solar cells: Tariffs on Chinese solar cells and modules will increase, potentially benefiting US companies in the renewable energy sector⁵ .

• Steel and aluminum: Steel and aluminum products, essential for manufacturing and construction, will also be subject to increased tariffs⁵ .

• Medical products: Certain medical products, including syringes, needles, face masks, and medical gloves, will face higher tariffs⁵ .

Potential Economic Consequences of Tariffs

The potential impact of new tariffs on the US economy is significant. One study estimates that the US could experience a loss of $27 billion in agricultural exports due to retaliatory tariffs from China⁶ . Furthermore, tariffs could potentially lower the incomes of American households, with estimates ranging from a 4% reduction for the poorest fifth to a 2% reduction for the wealthiest fifth⁷ . The tariffs could also negatively impact US investment, further affecting economic growth⁸ .

China's Response and the "China Plus One" Strategy

China has historically retaliated against US tariffs with its own protectionist measures, as seen in the 2018 trade war where China imposed tariffs on roughly $110 billion of US exports⁹ . This dynamic highlights the potential for an escalating trade war with broader economic consequences.

In response to rising tariffs and trade tensions, many companies are adopting the "China Plus One" strategy. This involves diversifying their supply chains by investing in manufacturing in other promising developing economies such as India, Vietnam, or Thailand¹⁰ . This strategy aims to reduce reliance on China and mitigate the risks associated with over-concentration of business interests in a single country.

Impact of Tariffs on the Global Economy

The US-China trade war has implications for the global economy. The 2018 tariffs resulted in estimated losses of $81.3 billion for the US and $63.3 billion for China¹¹ . Moreover, the trade war has led to global reallocations, with many countries experiencing growth in exports of products targeted by US-China tariffs¹² . This suggests that the trade war has created net export opportunities for other countries rather than simply shifting trade patterns.

The potential impact of new tariffs on the global economy is a cause for concern. Some experts warn that these tariffs could lead to chaos for businesses reliant on imports, disrupt global supply chains, and ultimately harm economic activity worldwide³ . Others suggest that while the tariffs may cause a short-term burst of inflation in the US, they could also prove deflationary for the rest of the world as surpluses emerge in traded goods¹³ .

Historical Performance of Pairs Trading Strategies During Tariff Implementations

While historical data specifically related to pairs trading during tariff implementations is limited, research suggests that pairs trading can be profitable in volatile market conditions, which are often characteristic of periods with significant shifts in trade policy¹⁴ . Studies have shown that a simple pairs trading strategy can generate average annualized excess returns of up to 11% for self-financing portfolios¹⁵ . These returns are often attributed to the temporary mispricing of closely related assets, a phenomenon that can be amplified by market shocks and uncertainty surrounding new tariffs.

However, it's crucial to recognize that pairs trading is not without risks. Market volatility and unexpected events can significantly impact the performance of even the most historically correlated pairs¹⁴ . The profitability of pairs trading can be influenced by various factors, including market risk premium, the presence of common factors in the returns of the paired stocks, and the overall economic climate¹⁴ .

ETFs and Other Instruments for Hedging Against Tariff-Related Risks

Investors can utilize various ETFs and instruments to hedge against tariff-related risks and diversify their portfolios:

• Inverse S&P 500 ETFs: These ETFs move in the opposite direction of the stock market, providing a hedge against broad market declines that may occur due to increased economic uncertainty or trade tensions¹⁶ .

• Currency-Hedged ETFs: ETFs that track the performance of the dollar against other currencies can help hedge against exchange rate risk, which can be exacerbated by trade wars and shifting global economic conditions¹⁶ .

• Commodity ETFs: ETFs that hold commodities like gold or natural resources can act as a hedge against inflation, which can be a consequence of tariffs and trade disruptions¹⁶ .

• Sector-Specific ETFs: ETFs focused on sectors expected to benefit from tariffs, such as domestic manufacturing or renewable energy, can provide targeted exposure to potential winners in the changing economic landscape¹⁷ . For example, investors could consider ETFs that track the performance of US steel producers or solar panel manufacturers.

• Gold ETFs: Gold ETFs, such as the ZKB Gold ETF, offer investors a way to hold gold as a hedge against inflation and market volatility, which can be heightened during times of trade uncertainty¹⁷ .

• Inflation-Hedged ETFs: ETFs specifically designed to hedge against inflation, such as the one launched by economist Nouriel Roubini, can help investors protect their portfolios from the potential inflationary consequences of tariffs and other economic policies¹⁸ .

Identifying Potential Pairs for a Pairs Trading Strategy

Given the potential impact of new tariffs on China, the following pairs of US companies could be considered for a pairs trading strategy:

Note: This is not an exhaustive list, and further research is necessary to identify optimal pairs based on historical correlation, financial performance, and other relevant factors. Investors should conduct thorough due diligence and consider the specific risks associated with each company before implementing a pairs trading strategy.

Conclusion

The implementation of new tariffs on China presents an opportunity for investors to implement pairs trading strategies in the US public market. By carefully analyzing the impact of tariffs on specific sectors and identifying historically correlated stock pairs with potential for divergence and convergence, investors can potentially capitalize on market inefficiencies and generate significant returns. However, it's crucial to acknowledge the inherent risks associated with pairs trading. Market volatility, unexpected economic events, and the complex interplay of global trade dynamics can all influence the performance of pairs trading strategies.

Furthermore, tariffs can have a broader impact on the economy, potentially leading to increased inflation, reduced consumer spending, and disruptions to global supply chains¹⁹ . The unpredictable nature of trade wars and the potential for retaliatory measures from China also add to the complexity of the situation²⁰ .

Therefore, investors considering pairs trading strategies in this environment should implement appropriate risk management strategies, including diversification, hedging with ETFs and other instruments, and thorough due diligence on the companies being paired. By carefully considering the potential risks and rewards, investors can navigate the complexities of the market and potentially benefit from the opportunities presented by the changing trade landscape.

Works cited

1. The Impact of US Tariffs: Which Industries Are Most and Least Affected - IBISWorld, accessed January 4, 2025, https://www.ibisworld.com/blog/us-tariffs/

2. The China Tariffs: Complex Consequences for U.S. Firms | Poole ..., accessed January 4, 2025, https://poole.ncsu.edu/thought-leadership/article/the-china-tariffs-complex-consequences-for-u-s-firms/

3. Tariffs on all imports would create chaos for business - Brookings Institution, accessed January 4, 2025, https://www.brookings.edu/articles/tariffs-on-all-imports-would-create-chaos-for-business/

4. US Tariff Increases on Chinese Imports: Implications on Businesses - China Briefing, accessed January 4, 2025, https://www.china-briefing.com/news/us-tariff-increases-on-chinese-imports-implications-for-trade-and-businesses/

5. Experts React: Energy and Trade Implications of Tariffs on Chinese Imports - CSIS, accessed January 4, 2025, https://www.csis.org/analysis/experts-react-energy-and-trade-implications-tariffs-chinese-imports

6. Trade Study: How Potential New Tariffs Could Impact U.S. Soybeans and Corn, accessed January 4, 2025, https://ncga.com/stay-informed/media/the-corn-economy/article/2024/10/trade-study-how-potential-new-tariffs-could-impact-u-s-soybeans-and-corn

7. Would Donald Trump's tariffs hurt US consumers? - BBC, accessed January 4, 2025, https://www.bbc.com/news/articles/c20myx1erl6o

8. The Effect of the U.S.-China Trade War on U.S. Investment - National Bureau of Economic Research, accessed January 4, 2025, https://www.nber.org/system/files/working_papers/w27114/w27114.pdf

9. Working Paper 19-7: The 2018 US-China Trade Conflict After 40 Years of Special Protections - Peterson Institute for International Economics, accessed January 4, 2025, https://www.piie.com/sites/default/files/documents/wp19-7.pdf

10. China Plus One - Wikipedia, accessed January 4, 2025, https://en.wikipedia.org/wiki/China_Plus_One

11. Waging A Global Trade War Alone: The Cost of Blanket Tariffs on Friend and Foe, accessed January 4, 2025, https://agpolicyreview.card.iastate.edu/fall-2024/waging-global-trade-war-alone-cost-blanket-tariffs-friend-and-foe

12. The US-China Trade War and Global ReallocationsMaximilian Schwarz provided excellent research assistance. E-mail, accessed January 4, 2025, https://www.nber.org/system/files/working_papers/w29562/w29562.pdf

13. How will Trump 2.0 tariffs affect the global economy? - UBS, accessed January 4, 2025, https://www.ubs.com/global/en/wealthmanagement/insights/marketnews/article.1677851.html

14. Examining Pairs Trading Profitability - Yale Department of Economics, accessed January 4, 2025, https://economics.yale.edu/sites/default/files/2024-05/Zhu_Pairs_Trading.pdf

15. Pairs Trading: Performance of a Relative-Value Arbitrage Rule - Wharton Statistics and Data Science, accessed January 4, 2025, http://www-stat.wharton.upenn.edu/~steele/Courses/434/434Context/PairsTrading/PairsTradingGGR.pdf

16. Hedging With ETFs: A Cost-Effective Alternative - Investopedia, accessed January 4, 2025, https://www.investopedia.com/articles/exchangetradedfunds/11/benefits-etfs-hedging.asp

17. ETFs to consider in a Trump 2.0 market - preparing your portfolio - Saxo Bank, accessed January 4, 2025, https://www.home.saxo/content/articles/equities/trump-20-etf-playbook-08112024

18. Roubini Launches New ETF to Hedge Against Inflationary Policies - Nasdaq, accessed January 4, 2025, https://www.nasdaq.com/articles/roubini-launches-new-etf-hedge-against-inflationary-policies

19. World Economic Outlook April 2019; Chapter 4 - The Drivers of Bilateral Trade and The Spillovers From Tariffs, accessed January 4, 2025, https://www.imf.org/-/media/Files/Publications/WEO/2019/April/English/ch4.ashx

20. Impact of Trump's Tariff Policies on Forex Trading | Trader - Vocal Media, accessed January 4, 2025, https://vocal.media/trader/impact-of-trump-s-tariff-policies-on-forex-trading

Note: This analysis is for informational purposes only and does not constitute financial or investment advice. If you observe any errors in numbers, figures, or other information presented here, please email me at [email protected].