Risk Trends Trembles, Is it the ‘Crazy’ Fed’s Fault
Market’s suffered a painful correction this past week. From peak-to-trough, the benchmark I like to refer to as a measure of hold-out enthusiasm, the S&P 500, dropped nearly 8 percent. That is still a ways from the technical ‘bear market’ designation which is a 20 percent correction from peak highs, but that scale of loss from a seemingly indefatigable climber rattles confidence. To be clear, the slump in sentiment was not isolated to the US equity market. That was just among the more remarkable victims of the speculative swoon owing to its typical outperformance. Looking across the other capital markets with a risk bearing, there were meaningful losses registered from foreign shares, carry trade, emerging market assets and more.
The intensity of these other assets however was notably less severe than what was registered from the lies of the S&P 500. Some would take this as an indication of source from and thereby restriction to US-based trouble. I, however, think this is just a retreat that is commensurate to how much premium there is to unwind. The US indices have continued there climb these past months while other related risk-profile assets have spun their tires either leveling out or falling into retreat. So, while the implosion by the Nasdaq 100 (dropping over 10 percent from peek) and its direct peers was violent, other sentiment forerunners like the EEM Emerging Market ETF registered smaller percentage declines to fresh multi-month or multi-year lows. The risk aversion was deeply rooted and carried wide influence. The question is whether the inexorable momentum behind a sentiment collapse is already underway. Much of that depends on motivation.
We still have event risk that has set off few alarms recently as well as themes like trade wars which cued few explosions beyond their already-troubling contributions. US President Donald Trump took a jab at the Federal Reserve who labeled the group ‘crazy’ for tightening the reins on policy and seemingly laid the blame at their feet. I don’t think they are really to blame for this move, but they certainly contribute to the environment that has necessitated it. Years of expansive monetary policy that stretched far beyond the need insinuated by the economic and financial recovery encouraged/forced speculative build up to unsustainable levels. When the inevitable withdrawal has to begin, the monetary policy authorities of the world are held hostage by a predicament that sentiment has been founded on these groups’ shoulders. Through the end of this past week’s plunge, there was a remarkable bounce through Friday – with the largest opening gap for the Dow since 2000 – which will tempt the Pavlovian response from dip buyers. However, the reversion to complacency will not hold forever. The gap between major market corrections is diminishing as recognition of the major fundamental risks grows. Remain flexible and have plans for bound or utter unwind.
Light at the End of a Trade War Tunnel?
We have seen some of the more prominent fronts on the on-going trade war find some measure of resolution lately. The holdout in negotiations between Canada and US was resolved and the three members are heading to a resolution that will bring about the USMCA (US Mexico and Canada Agreement). Whether the new program is more fruitful than the old one for the US or any other member is up for debate, but the fact that the threat of serious financial fallout from uncertainty in no resolution is not. Could his give some clue as to how the US plans to conduct negotiations to their conclusion with other countries in its line of sight? It certainly could stand as a template for the likes of Japan and the European Union (EU). These two major economies have not fallen into outright economic conflict with the United States. The willingness to appease in order to avoid the repercussions of lost business, investor and consumer sentiment in the face of verbal threats may show through.
However, that is not likely the case with China. The US has found comfort in going after a country many have decried for unfair trade practices in the past and they have already applied aggressive tariffs. That said, the US Treasury is due to release its assessment on China, including whether to label the country a currency manipulator or not. According to sources, they did not find the country met the designation, but that is up to Treasury Secretary Steve Mnuchin who will have the President’s words in his ear. The US is unlikely to back out of its engagement without some further concessions, while China has pushed back such that its cost to meet this high bar requirement may pose more significant damage to its effort of maintaining a balance of landing steady growth and holding financial stability.
Even if the situation was to be fully resolved as of tomorrow, it may have already pushed sentiment beyond a crucial threshold where recognition of more serious, systemic problems put us on an inevitable course. To add to this complexity, not all of the diplomatic scuffles are purely kept to decorous tariffs. The sanctions the US is returning to Iran are unlikely to be walked back, and that is creating greater tension with key trade partners (like the EU) which have economic and financial ramifications. Such economic/financial wars can escalate and get out of control faster than those who pursue them intend.
A European Threat Rising and Another Cooling
Europe’s fundamental health will take on particular importance over the coming week. Having ground on for over a year-and-a-half – and earning near-constant coverage in the meantime – the Brexit negotiations will hit another crescendo. The EU summit on Wednesday and Thursday is another one of the key last-minute turnoff points for the two sides to find common ground on the divorce before hitting a point of no return. We still have over five months before the official separation is due to take place, but there are still many political steps that need to be taken in order for a solution to be agreed upon and put into action before the cut-off date. This past week, there was yet another clearing in the ominous cloud cover when the EU’s chief Brexit negotiator, Michel Barnier, offered uncharacteristically optimistic remarks regarding the status of discussions between the two sides.
He noted the progress made recently and suggested a deal could be struck as soon as this coming Wednesday – when he has more consistently warned that they were heading down a path of the UK crashing out of the relationship. Yet, despite his enthusiasm, there are still key sticking points (like the Irish border); and reports over the weekend indicate progress stalled before important breakthroughs were made. It has been suggested they will not hold technical discussions again until Wednesday – which would insinuate this will have to be a top-level call. Tuesday, Prime Minister Theresa May is reportedly going to gather her Cabinet in order to cement a common front in the discussions over the days following. If there is a breakthrough by Thursday, expect the Sterling to have a considerable rally ahead of it. Should they again fail to find common ground, the mood will darken significantly as the clock winds dangerously short. Unfortunately for EU leaders, the two-day meeting will not be a one-topic event.
Besides Brexit, global trade strains and diplomatic troubles (between the US and Iran); the heads of state will have to address Italy. The third largest economy in the Euro-area, Italy has made clear its intent to bolster spending beyond the EU’s acceptable targets. The only scenario for which they will fall in line is based on an improbable forecast (a 1.6 percent or better GDP clip next year). This tests the tolerance of the collective versus the conviction of a member who has seen anti-EU sentiment grow out of economic struggle. Remarks by Italian leadership that the ECB could be a backstop if things grow too problematic for Italy in the market, only draw clear attention to the situation by global investors. The ECB’s reported rejoinder that such help would only come after a bailout only raises the specter of a return of the Eurozone debt crisis of six years ago. While official EU remarks surrounding this situation will be key, there are numerous other events that should be watched carefully to stay abreast of this situation. The Italian Prime Minister is due to speak the day before the EU meeting’s first day, the Finance Minister is set to speak, the Deputy Premier is on the docket for multiple appearances, but it is perhaps his visit to Moscow Wednesday that will draw some of the greatest scrutiny. Keep tabs on Europe.