We Have Unresolved Trade War Issues Guided by Rumor or Complete Blackout
We closed out this past week to a broad swell in risk appetite. This enthusiasm wasn’t consistent for the global markets throughout the week, however, with most of the asset benchmarks that I follow for scope were struggling until the Friday pop. The exception to the rule was once again the seemingly impervious US equity indices. Whether you were evaluating sentiment for the Dow and S&P 500 through the week or the global bump on Friday alone, the popular justification seems to have been the same: improvement on the trade war front. Given its importance to the course of the global economy, the contentious trade relationship between the US and China was naturally a point of regular speculation over the past week. The announcement of a ‘Phase One’ deal by the two economic powerhouses was announced back on Friday, October 11th. Since then, there has been far more speculation and rumor than there has been tangible policy change. Perhaps the only concrete development since that hailed breakthrough was the deferment of the planned October 15th tariffs escalation by the United States. This past week, the balance of headlines was neither consistent in trumpeting improvement nor did it offer foothold for genuine progress. Concern that China was cooling on agricultural goods purchases and balking at enforcement mechanisms while demanding rollback on existing tariffs contrasted the cheerleader-like language from some US officials (Trump, Ross and Kudlow).
It is hard to tell which of these headlines gives us the most accurate picture of this important economic relationships, but there is more consistency in the market’s interpretation of it all. Skepticism has set in some time ago and it only deepens with each week that passes without black and white terms for the Phase One deal for Presidents Xi and Trump to sign off on. As an aside, reports that a deal could be approved on the deputy level should raise concern. It suggests that it is not something the leaders would want their names affixed to; which should be a ‘win’ that they would want credit for, but would instead be viewed as either a more mediocre step or capitulation by both sides that could receive blowback by both constituencies. Keep a wary eye on the headlines for updates on this discussion as we pass implicit deadlines and the contentious explicit dates, like the December 15th increase of the United States’ tariff list of Chinese goods.
Perhaps even greater a threat of volatility – or opportunity for removing risk – is found in trade spats the US is fostering with the ‘rest of world’. This past Thursday was the supposed deadline for the Trump Administration to decide on the Commerce Department’s Section 232 evaluation for auto imports. This was the deadline after a previous six month extension. Through the weekend, there was still no word on whether import taxes on foreign autos and auto parts would be implemented, avoided or a decision postponed once again. Should it be delayed or completely avoided at this point, it would likely offer little boost to sentiment, but a sudden implementation would certainly trigger a significant slump in the global markets. Another dispute to keep on the radar is that between the US and EU. We have received very little insight on how negotiations are going between these two developed world leaders, but we know the US-applied tariffs on imported European agricultural goods is sowing ill-will among leaders.
Dow: Recharged Rally, New Plateau or Blow-Off Top
Though there is always room for debate, the performance of the US indices qualifies as one of the most remarkable of the global financial markets this past week. While ‘rest of world’ shares markets, emerging markets, junk bonds, carry and other sentiment-sensitive asset classes were sliding for most of the week, the Dow, S&P 500 and Nasdaq were holding steady or even advancing. This is not an unusual disparity of late. While the performance metrics change depending on your starting point, as a general benchmark for year-to-date 2019, a rolling 12-month comparison or plotting from the beginning of the recovery after the Great Financial Crisis concluded (roughly March 1, 2009), we find the ‘US market’ pacing the financial system. Determining the source of this outperformance can give critical insight into whether the bullishness will continue for local assets and whether it can establish more reliable traction across the world and asset classes moving forward.
There are some traditional fundamental measures that can referenced as sources of relative strength. The broadest measure of economic growth for the United States is certainly not roaring by historical standards, but it has held rather steady at its moderately expansionary tempo through the past years. That has in turn afforded the Federal Reserve an economic backdrop that allowed for rate hikes up through 2018 and offers some support for their stated intention to level out the benchmark rate range around 1.50 percent for the foreseeable future. A rate of return from the US offering a substantial premium versus most liquid counterparts while also having room to operate should future risks demand response is also beneficial. However, I believe much of this backing to this climb to record highs is based in sheer speculative appetite. Investors are willing to commit to their complacency, but they prefer to seek exposure where the progress is most consistent as that is where the greatest theoretical return would be made – while some may also justify their decision from a supposition of safety out of that climb.
Sentiment is fickle. Sometimes it can bulldoze through troubling updates while others it falters at any supposed crack. I would not, however, consider it reliable when you must dramatically increase exposure in order to extract further value out of the deal. If we consider the US indices’ particular outperformance paired with the lack of tangible fundamental catalyst through Friday, that impressive bullish breakout to end this past week does not look nearly as inspiring. Sure, the Dow gapped higher to clear out one of the most congested periods in the past few years (measured as a nine-day historical range as a percentage of spot), but follow through at progressive record highs requires steadily greater conviction. Unless something more tangible – like the wave off of auto tariffs – occurs, a recharged rally is really low on my probability list. A plateau would likely depend on some ‘catch up’ in other areas of the risk spectrum while pull of risk rebalance will be a constant force.
An Steady End-of-Year Coast for S&P 500 and Risk Markets Ala 2017?
If the genuine fundamental backdrop isn’t improving to support a stretch higher in capital markets, the next best thing seems to be complacency fueled by a perceived reduction in risk. We measure risk in the volatility of the underlying markets, and it is in that assessment that we find another questionable perspective whereby we seem to be pricing in perfection. The VIX volatility index has slid back to a remarkably deflated level around 12, which is the approximate low back to October 2018. Even more impressive though is the realized (versus implied) measures of activity. The past month (20-day) realized measure of volatility for the underlying S&P 500 is the lowest since the extreme quiet registered in the second half of 2017 – a period of such quiet itself, that we hadn’t seen anything comparable to it in half a century. We have further seen other exceptional readings such as the longest stretch with out a back-to-back loss for the same benchmark in decades and an exceptional record of days with lower than 1 percent registered moves from close to close. It is in other words very quiet.
With this quiet and the blatant complacency the markets have fallen back upon, it is easy to understand the efforts to ‘justify’ the next steps for a contentious climb. Reference made to the extreme quiet – and still-impressive progress – forged through the latter half of 2017 makes an appealing case study for bulls that may lack a more traditional foundation of conviction. There is another, more common point upon which investors may rationalize their interest in pushing their penchant for steady capital gains that can compensate for lost, reliable income through financial investments: seasonality. November and December are two of the most favorable months in terms of gains for the S&P 500 of the calendar year going back three decades for reference. Volatility also tends to retreat over this period which would add to that same incredible compression through the end of 2017.
Yet, be mindful of the reassurances you are willing to accept to keep on extreme risk. Just as many market participants will remember February 2018’s explosion as those that recall the third and fourth quarter of 2017. What’s more, there is even greater appreciation as to the exposure that has built behind this controversial speculative perch. A record net short positioning in VIX futures has made it into headline news. So has the general leverage in risk assets across the system – even record debt levels for consumers, governments, businesses and central banks. Suspension of reasonable risk rules paired with great awareness translates into a market that is more likely to be flighty and prone to avalanche. By all means, take advantage of prevailing trends; but don’t blindly continuously build your risk profile for steadily deteriorating return potential.