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Politics and market pricing; trade war deadlines; and recession responses - DailyFX Key Themes

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JohnDFX

Politics and Markets 

There are numerous, open political fissures around the world – including the approaching Brexit deadline; the ongoing flux of Euro-area stability and Chinese social pressure arising from economic concerns. Each of these represents significant headline fodder both within their respective country as well as in the international press. Yet, as many newspaper column inches or top headlines in online news aggregators these issues may represent, they don’t naturally adapt to clear economic or market impact. Evaluations are made over the prevailing trends and assumptions applied as to how these issues will work their way into tangible impediments to either growth or returns. That said, the uncertainty of all three of the aforementioned issues has unmistakably dimmed investors’ and consumers’ growth expectations. To ignore these matters when they are key motivators for a majority of market participants would allow a gaping hole in your analysis. Then again, it is easy to allow the drama of the headlines to overshadow the practical impact it may exert, allowing the natural passions of politics to take your well thought out strategy completely off the rails.
 
The difficulty in striking this fine balance is even more folly prone when it comes to the state of US politics. There has been an extreme divergence in party politics over the past decade and President Donald Trump has only fostered the divide. This creates a situation in which those in strong support of the White House allow their values outside the market paint a further exaggerated picture of an already complacent and exposed position, seen in the recent consumer sentiment surveys in which those reporting unsolicited enthusiasm for economic health via the President’s policies hit a record high. On the other end of spectrum, there are those that believe a recession is imminent through trade wars, political gridlock, dramatic debt expansion or income disparity. Naturally, the rise of the impeachment inquiry by the House of Representatives for interactions with the Ukraine exaggerates the reach into actual market impact. 

So how do we make a practical assessment as to what impact such political events can legitimately have so as to avoid emotions-based missteps and/or exploit the ‘wisdom of the crowds’. There are two measures of response that I typically expect in such developments: short-term and long-term impact. For the former, we can evaluate how much interest is concentrated on issue by using tools like Google Trends search or hashtag density for social interest to inform how likely a headline around the topic will leverage a market response. However, I prefer the empirical approach of assessing how much impact a related development will have on the market to set expectations for future updates. For long-term implications for growth and investor positioning, sentiment surveys such as the University of Michigan’s, Conference Board’s or Gallup’s for consumers or New York Fed’s for large investors can help course correct. Yet if you take the time each week or determine which developments are consistently taking control of the market most of the time through the bulk of the movement – what I consider rule number one for fundamental analysis – you’ll find yourself not as readily prone to finding the passions of politics drawing you away from the objective work of applying a successful strategy.  

Trade Wars Deadlines

When discussing the course of trade wars, most people would move to evaluate the state of play between the United States and China, and for good reason. These are the two largest independent economies in the world and their relationship has steadily deteriorated to the very costly detriment of the global economy since the first economic ‘shots’  were fired back in March 2018. However, to judge the course of the global economy and investment environment on the talking points between these two superpowers alone would be to miss the truly virulent threat in stalled global trade. There are some caveats to the particular US-China standoff that keeps it from readily inciting panic. Many developed countries consider China a long-term bad actor when it comes to fair trade and have so for many years. Therefore, they are willing to tolerate some degree of pressure. Also, there is an unrealistic assumption of the Chinese government’s control over the health of its economy and financial system born of the command style approach they have used for decades. Then there is dulled reaction time globally that follows a decade of bullish market performance which earns an unreasonable sense of immortality as it keeps buoyant despite supposed fundamental setbacks.

This confidence evaporates though if and when the altercations shift to encompass other developed world economies. The United States’ renegotiation of the NAFTA agreement seemed to have lifted its pressure on the markets as high-level agreement was made on the replacement USMCA. Yet, are have yet to see Congress approve the deal with Democrats asking for more and the year-end deadline is approaching. With many threats, we face tangible fractures between the two largest developed economies in the world this week as the WTO is due to deliberate the United States ability to apply tariffs for the claim that Europe had illegally subsidized Airbus for an uncompetitive advantage. This is a point of contention, but the risk lingering a seven weeks out is far more likely to provoke extreme retaliations on a global basis. President Trump received a report from the Commerce Department on the threat to national security inflicted by foreign auto imports. The White House had until May 18th to make a decision originally, but he deferred 180 days. That puts the deadline at November 14th. To suggest he wouldn’t go through with a tax on this competition would be to ignore the precedence already set. Also, the political pressure can also lead to more brash decisions. 

What Should We Expect If a Recession Hits? 

According to the New York Fed’s recession probability indicator – based on the increasingly popular Treasury yield curve – the world’s largest economy is facing a 38 percent probability of tipping into contraction over the next 12 months. Speculative interest/fear of this occurrence is significantly higher. Many have pointed out that previous instances of this same indicator rising to this level in the past have signaled eventual recessions in all but one instance. Further, there is also the increasingly popular belief that the chances of recession increase significantly as it is discussed and surveys reflect greater anticipation – a self-fulfilling prophecy so to speak. Google search ranking of ‘recession’ surged in the United States this past month to highs not seen since the actual Great Recession a decade ago. Further, other major countries have struggled with their own expansion – such as China running at a decades’ low pace, Japan notching negative quarters, Eurozone members contracting and more. With economic storms such as trade wars, Brexit and deteriorating monetary policy effectiveness weighing, it would seem prudent to at least prepare a contingency risk plan.

If a recession were to befall the global economy, how would it play out and what would the response to try and correct its course look like? As for the occurrence of a slump in global growth, there will be leaders and laggards to turn into the red. Some with artificial curbs to imported pain or unique sources of growth can hold back the tide for a little longer than others. Considerable attention will be paid to one of the sparks that would ultimately feed the consuming fire, but the recognition of the more prolific fuel – excess leverage throughout the system – won’t be appreciated until it is too late. Consumers, investors and politicians will demand action from the world’s largest central banks. They will attempt to lift the economy, but will come up wanting as they have little in the way of standard policy tools or even effective unorthodox means left to them after a decade of capital market padding. If the market recognizes their limits, it will only deepen the panic. Then the governments of the world will be expected to step in. Programs like the TARP and TALF in the US preceding QE will be unleashed, but these will not be any more effective this central bank stimulus. Coordinated response will be the greatest possible option, but the state of global politics has shown these authorities more interested in competing for limited resources (growth) than collaborating to create more for everyone. That will similarly deepen any crisis. Eventually, unprecedented actions would be taken, but after how much economic pain and investor loss? It is hard to tell. 

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