TACO logic

On 12 May, the United States and China reached an agreement that each would lower tariffs introduced in April by 115 percentage points for 90 days. And the stock market rejoiced; the S&P 500 rose by 3.3% that day alone. Later in the month, on 23 May, irked that the European Union would not just lay down and cry, President Trump announced a 50% tariff on EU goods, only to backpedal two days later (technically, these tariffs were just put on hold until 9 July). The S&P 500 fell by 0.7% on the first announcement, and rose by 2.1% on the second.

It seems financial markets got the picture. Seemingly shocking tariff announcement by a perhaps erratic president weren’t that much of a danger after all; he would surely back down after a while. The Financial Times coined the now very popular meme TACO trade – based on the idea that Trump Always Chickens Out. It remains to be seen if this meme changes his tactics.

The funny thing is that TACO trade has a very compelling logic to it. Even if you truly believe that Trump won’t live up to his initial threats, you never know. After all, that’s his standard operating procedure, keeping his opponents (and the markets) guessing. If so, there is more than a zero per cent possibility that it will actually happen. The chance is somewhere between 0% and 100% – so, rationally, the expected value is not zero and the market will fall.

Then, when he does backpedal, removing the initial uncertainty, the market rises again. Do note, however, that this recovery assumes the relief is not just temporary; after, say, 90 days, the US and China will not revert to their previous tariff war stances. And in July, the US and the EU will find a way out of this mess.

If, of course, such relief fails to come true, the consequences would be disastrous for the world economy. You might say that the market gambles on Trump not delivering on his promises. But you may then take comfort in the fact that you’re not alone in your optimism. According to FactSet, 12 months’ forward earnings estimates for the S&P 500 rose by 0.7% in May, back to just about where it was at the end of March. In Europe, estimates for the Euro STOXX rose by twice that amount. Clearly, financial analysts don’t see a financial disaster either.

Of course, there will be further setbacks – and further possibilities for TACO trades. Some of these will be very profitable, some of them may be on the really scary side. Do remember, then, that most of these short-run movements are just hiccups in a long-run trend of rising values fueled by rising company earnings. A Trump trade, or a TACO trade, is not a real investment.

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