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Risk appetite despite trade wars; Dollar motivation; political risks rises - DFX key themes

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JohnDFX

Trade Wars Update: It No Longer Matters? 

Seemingly a routine occurrence for the global financial markets, we saw the state of global trade deteriorate yet again through the past week. As expected, the United States went forward with tariffs on an additional $200 billion in Chinese goods. The terms are for a 10 percent rate on a range of imports that will increase to 25 percent by the end of the year. The standard, immediate response from China was quickly implemented, but only on $60 billion in US goods. It is not clear the strategy from China as they vowed a ****-for-tat response to what they have deemed unprovoked trade wars, but the country does not have much more room to tax imports from its major counterpart – and certainly not $200 billion worth of goods. This alone moves us into a new phase of a standoff of escalating cost for the US, China and the world. 

Will China ease off the pressure? Are they simply plotting an alternative course? Could this be an attempt to prevent President Trump from pursuing his threat to trigger the $267 billion in further duties in the event of a reprisal to the $200 billion? It isn’t clear. With the situation clearly under greater tension, the news over the weekend that plans for further talks had broken down ensures greater financial threat from this already-enormous burden. What is even more remarkable than the state of trade from these two economic leaders is the apparent state of obliviousness from the speculative markets. While certain assets show greater disregard to the threat than others (the S&P 500 is at a record high while the EEM Emerging Market ETF is only modestly off its multi-year low), they have all displayed a measure of neglect these past weeks as the tab has grown exponentially. 

To suggest that this situation simply doesn’t matter would be recklessly negligent. It isn’t impossible that speculators accustomed to complacency and FOMO, but it would nevertheless increase the scope of risk to stability through the future. Ignoring the dangerous wobble in a tire as you steadily accelerate down the freeway is not a reasonable state even if we can sustain it for the time being. If we continue to build up exposure until a severe economic or financial crisis arises, it will only amplify the eventual collapse. 

What is Eating the Dollar and How Long Does it Dine?

The Dollar marked an important technical tumble this past week. Already under pressure over the past months, the DXY’s drop below 94.35 and EURUSD charge above 1.1700 represents the break of ‘necklines’ on head-and-shoulders patterns (the latter inverted). This is pressure not isolated to the trade-weighted aggregate or its heavily represented most liquid pairing. We can see the currency’s unique struggle intensifying distinctly across the spectrum over these past few weeks. But with this evidence of broad struggle, we should attempt to identify its source if we intend to establish the intent of follow through – whether persistent or near its conclusion. Reverting to an old textbook relationship, some are connecting the currency’s traditional safe haven role to the recent rebound in risk assets – including record highs for certain benchmark US indices. 

That would be a tidy explanation, but is suspicious for its timing considering this haven function hasn’t played a significant role for months. Further reason to question this relationship is the explicit status for the Greenback as the highest yielding major currency. That advantage will likely increase this week as the Fed is expected to hike rates another 25 basis points to a range of 2.00-2.25 percent. It could be the case that the currency’s premium could be deflating under expectation that the central bank is planning to downgrade its pace of tightening at this meeting through the Summary of Economic Projections (SEP) and Chairman Powell’s press conference. Yet, we don’t see that anticipation in assets that more directly relate to such forecasts - overnight swaps and Fed Funds futures. 

Political risk will prove an increasingly prominent risk through media headlines in particular over the coming weeks, but there is little direct threat to economy or financial markets just yet. This slow reversal of a six-month old bull trend may also have developed in response to the longer-term concerns. Over enough time, the accumulated cost of engaging in a multi-front trade war while increasing the budget deficit during a healthy economic phase will erode the appeal of the United States’ currency’s principal status. It is possible that this long-term pressure is starting to set in; but if that is the motivation, it can readily be sidetracked by more intense short-term concerns (like next week’s FOMC decision). 

Political Risk Increasing as US Election Cycle Heats Ups 

Political risk is an abstract fundamental influence on the financial system. Certainly each trade has their political beliefs on policies ranging from economy to social causes; but more often than not, these views only cloud our assessment of the markets. It is generally-accepted market wisdom to remove emotions from our trading; and there are few things in life that more readily trigger emotion than politics. Practically-speaking, however, there is little in the way of policy that can readily translate into significant market movement in the short-term. That said, one of the few outlets with a direct link to financial health and stability is the state of international relations. And, on that front, the danger has grown visibly and exponentially. Perhaps one of the most obvious instances of this pressure on net global growth and capital rotations through trade comes from the United States. 

The Trump Administration has driven forward with hefty tariffs and economic sanctions on some of the largest economies in the world. Whether we personally view the policies as good or bad / right or wrong, the economic impact is straightforward. As time marches on, attention on politics will intensify with the mid-term elections approaching. While much of the high drama related to the balance of the Legislative branch, threats of Presidential impeachment and the Supreme Court pick has little to do with the kind of direct market implications that we should keep in the forefront; it can nevertheless bolster the appreciation of economic and financial connection by virtue of its mere presence in the headlines. What’s more, this is not a uniquely US concern. There is political pressure rising across the world. 

Reports of a possible election call in the United Kingdom have followed the failure of progress in the Brexit negotiations at the EU leaders summit in Salzburg. Mainland Europe is not immune to systemic risk via political pressures. Italy is still a massive concern to stability between its enormous debt and populist government. Poland and Hungary pose a threat to core EU beliefs – and have drawn criticism for such – owing to their nationalist governments’ policies. In Asia, financial pressure is starting to show subtle cracks in social contentedness while US sanctions have spilled over from Russia restrictions. Japanese Prime Minister Abe managed to keep his position this past week, but the economic and international diplomatic position or the country has not improved materially. The question investors should ask themselves is whether these relationships improve for compromise or rapidly intensify should economic or financial crisis start to emerge. 

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Great insight covering a wide arena as usual, this blog is an excellent follow and an extremely useful overview of what's going down on the global stage with targeted reference to the subsets of macro politics and economics.

Of particular interest is the US/China trade dispute, with the Dow and other US indices reaching at all time highs in the middle of a trade war is remarkable. My own assumption is that the markets know Trump wants to make a deal that will go some way to rebalance the tilted playing field that is the result of US open market against the restrictive controls imposed by the peoples republic. Any deal that is a small step in that direction will suffice, for now. China are running out of imports to tariff and have resorted to taking out multi-paged newspaper adverts. It is possible that any kind of a deal where both parties can claim victory is not actually that far away and that could be the spring board for a new leg up for US indices and consequently other western markets as well.  

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