Market Strategy Radar Screen Weekly October 22, 2018

The Times They Are a-Changin’

As we quote Bob Dylan, we think “and that ain’t such a bad thing”

Markets and investors are currently bearing the burden of transitions taking place around the world as currencies fluctuate, stocks bounce between gains and losses (depending on the sentiment du jour) and interest rates point higher, even if hinting at a lack of conviction as bond traders play the game of price discovery.

It’s not quite a “gird thy loins moment,” but it requires patience and perhaps a level of confidence and conviction that investors have not had to call on for some time (recall 2017 when market volatility was at historical lows?).

The old saying is that “markets don’t like uncertainty.” Another is that "people don’t like change”—and in fact resist it.

The good news we believe is that historically from uncertainty usually comes not only risk but also significant opportunity as progress emerges from the process of change— particularly when it’s a change for the better.

From our perch on the Market Strategy Radar Screen, we expect that issues surrounding the trade war between the US and China will be with us at least through the US mid-term elections. It’s generally recognized that China’s leadership has shown a reluctance to give the Trump administration a deal that might help the president’s favored candidates garner winning votes on November 8.

The period after the election will likely offer the next opportunity for China to come back to the table and negotiate a deal with the US.

In the meantime, China’s economy continues to show signs that growth is slowing: Bloomberg shows the country’s GDP grew 6.5% in Q3 from a year earlier. China’s monetary policy makers are having delicately to balance between providing liquidity to the system while trying to avoid allowing a degree of accommodation that could place the economy in jeopardy of a financial crisis, led by the indebtedness of many of China’s state-run enterprises and local municipalities as well as real estate investments that have run too hot for too long.

With the effects of the tariff war already being felt to some extent by China’s manufacturers and exporters, we believe there’s an incentive for China to return to the bargaining table and strike a deal with the US.

For the US, the sooner a trade deal can be arrived at with China, the more likely that further damage to the US economy (particularly the agricultural sector) can be averted.

Just a little over three months ago (in July), the second tranche of tariffs was launched by the US with China retaliating shortly thereafter. Several more volleys have been levied by both nations since then as trade hostilities have heated up further.

There appears to us too much to lose for all sides involved for the trade war to go on indefinitely. The wrath of trade wars historically spares no one but rather ravages all involved.

Businesses in the US and in China are eager to get beyond the trade skirmishes and move toward resolution to the tariffs thus far imposed before these burdens disrupt what had been up to the start of the trade wars a global economic recovery, led by what had become a sustainable economic recovery in the US.

China has its goals and objectives for the “Made in China 2025” plan that could be significantly delayed by a protracted trade war.

US Businesses Also Fret About the Uncertainty

For the US, further progress of its economic expansion could be disrupted as businesses delay making investments in an environment in which tariffs threaten the highly complex supply chains and production systems.

Ironically, the US efforts to bring existing and recent trade agreements up to date and in line with a world in which globalization and technology have become deeply embedded are instead raising hurdles that threaten to disrupt a world economic recovery that was hard-earned by central banks.

Experience dealing with parallel challenges to economic growth derived from geopolitical roots in the past tells us that so long as leaders meet and talk, there’s a good chance for resolution.

Trump and Xi Expected Meet at the End of November

The G20’s meeting in Buenos Aires scheduled for late November offers the next best opportunity for the US and China to meet “mano a mano” (president to president) and hopefully find a workable resolution to what has become a regrettable standoff.

Until some progress is made at such a geopolitical level, markets are likely to remain under an overhang of uncertainty that will result in periods of market volatility in the months ahead.

Doubting the Fed

Aside from trade wars, the other principal concern du jour moving markets of late has been that the Federal Reserve will make a mistake in either raising rates too fast or too high (causing the economy to slip into a recession) or too slowly and too late—thereby feeding inflation.

Based on the Fed’s performance since the fall of 2008 (through two prior and now the current Fed chairs), a Fed mistake does not seem imminent, in our view. The central bank has thus far shown remarkable sensitivity to both strengths as well as vulnerabilities in the economy in implementing a process of interest rate normalization.

The ability of the Fed to have thus far avoided making a significant mistake in its efforts to nurture an economic expansion from the ashes of the financial crisis, we believe, has to do with its improved capability to gather data as well as to crunch numbers as a result of improvements in technology.

As we have mentioned in prior issues of the MSRS Weekly, the Fed in the current rate hike cycle has raised only eight times in under three years compared to 17 times in the last cycle (from the end of June 2004 to the end of June 2006). All these moves have been in increments of 25 basis points.

In the current hike cycle, the Fed has raised its benchmark rate from a band of 0% to 0.25% on December 16, 2015, to a band of 2.00% to 2.25% when the FOMC met on September 26th of this year. In the last cycle, the Fed raised rates from 1% to 5.25% over the 24-month period.

It’s not surprising to us that as the benchmark rate has risen, market rates have begun to adjust upward as well (albeit to levels far from historically high), causing mortgage applications to slow, auto sales to have tapered and some businesses (particularly those relying on high levels of borrowing) to begin to feel the pinch of higher rates.

Those who have experienced previous hike cycles will recall that some slowing in lending is not uncommon, particularly as borrowers consider the relative higher cost of money to what they recall in recent memory was a lower cost “only a short time ago.” This reaction is likely to be especially felt at first in an environment where interest rates have been abnormally low or what has been a period of nearly “free money” for much of the past ten years.

In an environment like the one we are currently experiencing, investors should find that practicing patience and seeking opportunities that present themselves to be good discipline.

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