It’s Okay, This One is On the Fed
There has been a notable shift in the market’s mood in just the past week. A sense of dull complacency that traders who were active during the first wave of the large scale, central bank stimulus infusions would recognize has bolstered key assets. After the benchmark S&P 500 and Dow topped at the beginning of May, a steady slide in the indices encouraged the same sinking feeling in conviction that was dependent on complacency. Evidence that we are the late stages of the economic cycle, the business cycle and the market cycle is piling up. Normally, as the pace of expansion flags, we find the market’s tolerance for lowered speculative potential is partially offset by higher rates of return as the demand for funds drives yields higher. However, the record-breaking bull trend that we have enjoyed over the past decade defied that particular convention as its initiation and extension was supported through extreme accommodation from central banks – first lowering interest rates to record levels and then adoption quantitative easing measures. While this would help stabilize financial markets and help stimulus growth, it would also necessarily lower rates of return to be expected from the investing.
After a while, it grew more and more apparent that the latter waves of support produced less and less traction towards economic objectives (bolstering economic output and inflation) but they nevertheless ensured a lower baseline for expected returns. With a presumption of indefinite support by monetary authorities and a highly competitive financial market, it should come as little surprise that moral hazard would thrive. It is that base assumption that exceptional risks taken in recent years to drive assets of questionable value to record high prices (like the S&P 500) would be discharged by the Fed and its international peers. The anticipation is impossible to miss in the markets with Fed Funds futures pricing in an 85 percent probability of a 25 basis point cut by July and a healthy chance of multiple cuts before year’s end. Considering President Trump has called out the central bank multiple times over the past months and economic warning signs like the inversion of the 10-year/3-month yield curve have garnered greater attention, the assumption of more assistance comes as little surprise. Language from the Fed Chairman Jerome Powell, other board members and even official communiques have also made clear a willingness to step in should growth stall.
My concern is not whether the Fed and others will step in should we lose traction, but rather what happens as we realize their limited capacity to extinguish further financial fires. The Fed arguably has the greatest capacity of the major central banks as it has tightened rates around 200 basis point since its first hike in December 2015. Yet, that isn’t a particularly sizable arsenal when we consider how little economic amplitude we leveraged from the massive stimulus programs and given how much more premium in capital markets they are expecting to keep propped up – the S&P 500 rose another 39 percent beyond 2015’s peak. If actions by the Fed fail to steady the market, it would do far more damage to sentiment
Don’t Forget the Trade Wars Are a Thing
With the recent rebound in speculative market benchmarks, there is an innate tendency to seek out favorable fundamental winds in order to justify the prevailing bias. Anticipation of further support from the Federal Reserve is one such rationalization for speculative lift, but another potential source of confidence heading into the new trading week is the Friday evening news of a trade war breakthrough. Following the week’s end market close, President Trump announced in a tweet that a deal had been reached with Mexico for the country to take action on stemming migration through the country destined for the United States in order to avoid a 5 percent blanket tariff on all Mexican exports destined for the US. This warning was made less than two weeks ago and it was roundly criticized by members of Congress, US business leaders and (reportedly) even White House senior staff. That means the market likely maintained a hefty skepticism that the threat would ever be put into action. As such, we now await the new week’s open to see if there is a flush of relief rally to play out or if the markets will struggle despite the faux breakthrough.
Meanwhile, progress on one front of trade dispute for the US could be used as justification to escalate tensions on another in a bid to force capitulation. The last official action in the US-China standoff was a hike in the tariff rate by both countries on each other’s list of target goods ($200 billion and $60 billion worth respectively). Treasury Secretary Steven Mnuchin said over the weekend that the President would be “perfectly happy” to fulfill his vow to expand the list of taxed imports to all of China’s trade – over $500 billion in goods and services. If imposed at the prevailing 25% rate, that would translate into an incredible 250% jump in the notional bill of the trade war on just one side of the battle line. Perhaps even more troubling would be China’s inevitable retaliation. The country has already maxed out the like-for-like goods for which it can impose a tax. That would mean it would have to resort to further unorthodox means.
With the US already moving to ban Huawei, it seems inevitable that the Asian giant would move to blacklist a number of important US technology companies. It is also very likely that it would throttle shipments of rare earth materials – for which it is the world’s largest producer – to hit the production of cellphones and other consumer technology. While that bill will add up over time, it is likely that China will pursue additional means of pressure in order to have a more pointed effect. A concerted selling of US corporate assets is the next logical line, but many are watching for Yuan depreciation or a strategic selling of Treasuries. Those are unlikely however as the financial repercussions would be too severe with necessary losses in their own capital exposure and a high probability that other countries rally to the United States’ cause.
An Inconvenient Time to Worry About Eurozone Stability
With the US Dollar losing viability owing to its pursuit of trade wars that undermine global stability, the Pound plagued by a directionless Brexit and the Japanese Yen lost in a deflationary quagmire, there is an acute need for a stable benchmark currency. Despite its many fundamental shortcomings, the Euro showed itself willing to offer an outlet for liquidity over the past few years as the recovery from the region’s sovereign debt crisis between 2009 and 2012 seemed to offer a sense of hard-fought stability that was prized above all else. When the European Central Bank (ECB) veered off its course to normalize policy following the December cap on its open-ended stimulus program – by implementing a new targeted-LTRO – the Euro’s appeal deflated significantly. With a renewed sense of dubiety, we have seen attention turn to other cracks in the Euro’s perceived durability. Perhaps the most tangible of the unique risks facing the shared currency is the pressure brought by its third largest member: Italy.
The coalition government of staunch anti-EU parties has struggled to find a common cause outside of the general revolt against the European cause. After the Prime Minister threatened to resign over infighting by his government, the coalition parties seemed to settle their differences for now but that would not translate into any renewed support for the Union. In fact, the unifier between these extreme parties seems to be their agreed-upon discontent. Last week, one of the deputy Prime Ministers stated clearly that Italy would not change course from its plans to offer its citizens relief through tax cuts. In the meantime, the European Commission found the country warranted a preparatory document on disciplinary action over its financial position. According to deputy PM Salvini, this could amount to a 3 billion euro hit. The country and Union leadership can draw this fight out for some time before we reach the limits of financial stability as Greece showed us nearly a decade ago, but the market is unlikely to allow the pressure to build up for that long before it starts to price in a systemic threat. In the week ahead, the Eurozone and European Union finance minister meetings will no doubt discuss this situation, and any uniform positions will not pass unnoticed.
Generally-speaking, the Euro would not retain the same global reserve that it represents today if one of its core members were to make a credible threat of withdrawal. That is still very unlikely, but there are first stage cracks that are being threatened that could build an unplanned head of momentum: It has been suggested that Italian authorities are considering the use of an ‘alternative currency’ to service its debt, a move that naturally ushers in reasonable speculation of a stability concerns underlying the Euro. As the second most liquid currency comes under pressure, it is natural to keep tabs on the only more ubiquitous benchmark – the Dollar – but I believe gold is the best measure to our particular set of financial uncertainties as the 2009-2011 period surge stands out for those seeking alternatives to the traditional currencies.