Posts tagged Geopolitics & Markets
Remember last Friday? Investors were in the sunniest of moods, with another month of robust job numbers on top of a better than expected first quarter GDP reading. Even productivity was improved, as we mentioned in our commentary last week (not that anyone was paying attention to the single most important economic growth measure). It was shaping up to be a merry, merry month of May…until late into the weekend when the Twitterverse called investors away from their barbeques to inform them that the trade war was back on the table. Uproar and consternation! Chinese markets, which were already open, quickly went pear-shaped and financial media outlets set up the talking points for the week.
Trade war? Wasn’t this as close to a done deal as these things get? The presumed cessation of hostilities between the US and China on trade was widely accepted by market participants as one of the two primary tailwinds for the 2019 rally in risk assets (the other being the Fed’s pivot on interest rates). By the time the S&P 500 hit a handful of new record highs in late April, a successful outcome to the long-festering trade dispute was conventional wisdom. The Chinese delegation, led by Vice-Premier Liu He, was due to arrive in Washington on May 9 for a round of talks which, if not necessarily definitive, were at least supposed to affirm the intention of both sides to reduce tensions and maintain support for global trade (through bland platitudes if not much else). Instead, those tweets by Trump late in the day on Sunday put new tariff threats back on the table and upended the conventional wisdom.
Jittery Algos, Jaded Humans
Two years into this administration, most cognitively-endowed human beings have learned a thing or two about digesting news from Twitter, particularly that which emanates from one particular account on Pennsylvania Avenue. The performance art of grandiose pronouncements which eventually dissolve into nothingness has become routine. This wasn’t entirely clear when the trade war first started to spook markets in early 2018. But the absence of tangible actions to match the rhetoric of the tweets, along with this administration’s obsession with where the Dow is on any given day, eventually made it clear to anyone paying attention that there wasn’t much in the way of bite behind the bark.
Algorithms, bereft of those cognitive abilities, are not so sanguine, which partly explains this week’s pullback (a natural pause following an extended bull run also being in the mix). The quantitative models powered by these algorithms make up the bulk of intraday trading volume. Many of them are wired to respond to –yes, really – stuff that comes out on Twitter. So the Sunday tweets begat the Monday blues. But even algorithms have a natural stopping point. As we write this on Thursday morning, the S&P 500 is around three percent off its recent high. That’s not much, especially considering that the blue chip index had racked up gains of almost 20 percent when it set the most recent high on April 30.
It’s much less, in fact, than would be the case if the collective wisdom of human and bot traders alike determined that an honest to goodness trade war was the most likely outcome of the current state of play. Fortunately, the evidence against that outcome remains compelling. It’s performance art, and as long as neither US nor Chinese negotiators want to explain to their constituencies (and, in our case, voters) why the economy collapsed on their watch it will likely remain thus.
In the canons of Fed Scripture there was the Greenspan put, which begat the Bernanke put, which begat the Yellen put, and the Governors saw that it was good, and the Governors rested on the seventh day. And then came Jerome Powell, and the put was no more. Or was it?
You’ve Got a Friend at the Fed
For those not steeped in the arcane speech patterns of those who inhabit and/or observe the goings-on in the Eccles Building, the “Fed put” is the widely-held assumption among investors and traders that whenever risk asset markets get choppy, the Fed will be there to ease the pain with a fresh punch bowl of easy money.
Case in point: in the early months of 2016, just after the Fed had raised rates for the first time since the 2008 recession, global equities took a hit from some negative economic data from China. Now, nobody in the Yellen Fed at the time ever actually came out and said “the S&P 500 fell more than 10 percent, so we’re going shelve the rate hikes for a while.” But investors could draw their own conclusions – rates did stay on the shelf, not rising again until the end of 2016, a full year after the first increase.
For much of the current recovery cycle the colloquial Fed put was part and parcel of the formal monetary stimulus policy to get the economy back on its feet. Encouraging investors to shift out of low-risk assets like government bonds and into riskier things like equities was a central feature of the system. But those days are over. When stocks lurched into a downturn back in early October it seemed that the market finally got the memo – the FOMC (Federal Open Market Committee, the Fed’s monetary policy decision arm) had raised rates again in the September meeting, were on track to do so again in December, and Fed chair Powell was quoted in a speech as saying that current rates were still far away from the neutral interest rate. The economy’s doing well, corporate earnings are fine, no need to keep the training wheels on…right? Investors seemed to think otherwise, and Red October was on.
A Lighter Shade of Neutral
Let’s go back to that Powell comment about the neutral rate, because it figures very much into what the market has been up to this week. First of all, what exactly is the “neutral” rate of interest? Glad you asked, because even the cerebral Fed folk themselves can’t give you a clear answer. It’s supposed to be whatever rate of interest is neither stimulative (too low) nor restrictive (too high). The various members of the FOMC have their own ideas, which fall out into a range of about 2.5 to 3.5 percent based on the most recent “dot plot” assumptions the Fed releases periodically after the FOMC meets.
On Wednesday this week, Powell once again referenced the neutral rate. This time, though, rather than saying that rates were currently “far away” from neutral, he said they were “just below” the range of neutral rate estimates. The market went into a tizzy again, but this time in a good way with major indexes jumping more than 2 percent. And so the excited chatter resumed…is that a Powell put we see out there? We may well be wrong about this, but we tend to think not.
Do the Math
Currently, the Fed funds rate is in a target range of 2.0 to 2.25 percent, which puts rates…well, just like Powell said, “just below” the range of neutral rate estimates. The chart below illustrates this.
But why did investors obsess over those two words “just below?” Here’s how the math works. The midpoint of the current Fed funds range is 2.125 percent (i.e., halfway between the floor of 2 percent and ceiling of 2.25 percent). The FOMC generally likes to see the effective rate (i.e. the actual market rate banks charge each other for overnight loans) somewhere close to the midpoint.
So, to get that midpoint rate above the 2.5 percent lower boundary of the neutral rate range would require two additional rate hikes (presumably one later this month and one sometime next year). To get to the midpoint of the neutral range, a more likely outcome, would require three or four additional rate hikes to get to 2.875 percent or 3.125 percent (i.e., either side of the 3.0 percent midpoint neutral rate).
Three or four additional increases…wait, isn’t that what the Fed has already signaled it plans to do? Why, yes! One in December and then two or three in 2019 is the default assumption coming out of FOMC press releases and commentary since at least the middle of this year. So why all the fuss? Parsing what exactly Powell meant by “far away” or “just below” or any other combination of two words would seem silly, if the math seems obviously the same as it has been for months already.
One reason given for all the investor excitement was that Powell’s comments on Wednesday came right on the heels of another blast of word salad from the nation’s chief Twitterer complaining about the Fed and higher interest rates. Was the Fed chief bending the knee to Trump like so many other seemingly reasonable people have in the past two years? Is the Fed put back in the policy bowl because Trump wants low interest rates?
While one can never say never in this day and age, we see very little likelihood that the head of the Federal Reserve, charged among other things with maintaining the independence of the central bank, would immerse himself into the middle any political imbroglio. The timing may have seemed strange, but there just is no factual basis in which to read any kind of political message from Powell’s speech. He did say that there is no “preset” path for rates – which is what the Fed always says. Data about the health of the global economy will inform the pace of interest rate policy. If growth appears to be slowing or going into reverse then there will likely be fewer rate hikes, while if the pace continues to hum along at current levels there is no reason to assume anything other than the four rate hikes already baked into policy expectations.
We’ll get a preview of whether our analysis is correct or not in just a few short weeks when the FOMC meets for the last time this year. There are just a handful of macro data points coming out between now and then, and barring a very unexpected surprise either from the labor market or consumer price readouts, we don’t see anything to suggest the December Fed funds increase won’t happen. Hopefully Mr. Market will be able to figure this out in a relatively drama-free fashion.
There were lots of think pieces leading into the US midterm elections earlier this week. We didn’t contribute to the genre, mostly because there is nothing statistically meaningful to say about an event with a very small sample size (n = 10, if you want to go all the way back to 1982 for your midterms data set) and lots of variables highly specific to each observance. Not that shoddy statistics ever got in the way of mainstream financial punditry…but we digress. In any case, the day came and went with relatively few real surprises of note. The “known unknowns” of the midterms now join the headline macroeconomic and corporate earnings trends as “known knowns” propelling what might be expected to be a net-positive narrative while the clock runs down on 2018. Always allowing, of course, for the sudden appearance of an “unknown unknown” to spoil the applecart (and thanks to Donald Rumsfeld for his contribution to the lexicon of predictive analytics).
Good Cheer and Relief?
The relief rally that began last week would seem to have some seasonal tailwinds to carry it further. The holiday retail season gets underway in a couple weeks, and it is shaping up to be a decent one. The latest batch of job numbers released at the end of last week suggest that higher wages are finally catching up to the rest of the good cheer in labor market data points. Consumer prices are still in check, despite the gradual encroachment of new tariffs onto consumer goods shelves. A good showing between Black Friday, Cyber Monday and the ensuing week or two could keep investors focused on the growth narrative.
Potential headwinds to that growth narrative are also at play, however. The Fed will meet again in the middle of December and is expected to raise rates for the fourth time this year. That by itself is not new news. In their little-publicized (non-press conference) meeting this week the FOMC reiterated confidence in the economy’s growth trajectory, which sets the stage for next month’s likely increase to the Fed funds target rate. What the Cassandra side of the investor world has in its crosshairs now is the US budget deficit, which is positioned to climb above $1 trillion in the near future.
Again – not a new fact, as this figure was well known when the Republicans implemented their sweeping corporate tax cuts one year ago. What is known with more certainty now, though, is that the higher levels of debt servicing that accompany this swelling budget deficit will happen at the same time as interest rates are heading off the floor towards levels closer to historical norms. Now, the newly known fact of a split Congress may mitigate some of the debt concerns – after all, further fiscal profligacy is unlikely in a Congress that will be hard pressed to get even the simplest pieces of legislation passed. And some optimists still maintain (without much in the way of supporting evidence) that the net effect of the tax cuts will be an unleashing of business productivity. But the debt servicing issue has the potential to be a decisive influence on US credit markets heading into 2019, which could mean trouble for risk assets.
The Big Unknown
Now we come to the part of the discussion where the specific risk factors become harder to pin down, but have the potential to overwhelm conventional wisdom. We’re talking about politics – world politics, to be sure, not just US politics. Assets in developed markets typically ignore, or at least give very short shrift to, socio-political developments. Even singular events that at the time seemed momentous – the Cuban missile crisis and the Kennedy assassination in the early 1960s come to mind – scarcely had any effect on prevailing stock market trends. The same goes for Watergate – the losses sustained by US stocks in the summer of 1974 were largely in line with the broader forces at play in a secular bear market that lasted from 1969 to 1982.
Markets don’t ignore these events because they are Pollyanna whistling her merry tune – they ignore them on the basis of a well-grounded assumption that the political institutions of modern developed nation-states are robust enough to withstand the impact of any single imaginable happening. The institutions though – and we are speaking here primarily of the US, the EU and the latter’s soon-to-be divorced partner across the English Channel – are being challenged in ways unknown since the post-Second World War Bretton Woods framework came into being.
How could the further dissolution of Western institutions affect investment portfolios? One can speculate, but with little in the way of hard data for modeling alternative scenarios. It may well be that nothing much impedes on investor sentiment in 2019 beyond the usual store of data regarding economic growth and corporate sales & profits. Those numbers may be strong enough to keep the good times rolling for a while longer. But the tension will likely form at least a part of the contextual background. However the numbers end up, we do not expect calm seas along the way.
2011, 2012, 2015…ah, memories of summertime Eurozone crises past. On the cusp of the summer of ’18 it would appear not entirely unreasonable to imagine that we are due for another languid spell of troubled waters across the Atlantic. Political dysfunction in the southern periphery was on full display this week, first with Italy’s fumbling attempt to form a new government and then with a no-confidence vote shoving Spanish PM Mariano Rajoy out of office in favor of Socialist Party leader Pedro Sanchez. Word is that Rajoy sat out the parliamentary hearings leading to his ouster, choosing to spend those eight hours in a Madrid restaurant instead. Respect.
Oh, and the US went ahead and imposed steel and aluminum tariffs on the EU, leading EU trade commissioner Cecilia Malmstrom to pronounce a “closed door” on EU-US trade liberalization talks. Abandon hope, ye bourbon drinkers of Europe. The euro continued its slide while investors hugged onto German Bunds like a Steiff bear, illustrated in the charts below.
The big drama this week, of course, came courtesy of Italian president Sergio Mattarella as he gave a Roman thumbs-down to the cabinet submitted by the recent populist partnership of the Five Star Movement and Northern League (see here for our analysis last month of the implications of this partnership). The move caught investors by surprise and Italian bond yields soared (the blue line in the leftmost chart above).
It may seem counterintuitive that Mattarella’s move sparked a negative market reaction. After all, his opposition to the cabinet slate was focused on the proposed finance minister Paolo Savona, an outspoken critic of the single currency union. The resulting impasse with the FSM/League coalition led to a proposed caretaker government led by Carlo Cottarelli, a former IMF official. That sounds awfully market-friendly…but no, investors read this as a resurgence of the “in or out” question that last reared its head with the Greek financial crisis of July 2015. The thinking was that Mattarella’s technocratic move would give a new tailwind to the Northern League (which indeed has seen a sizable bump in the polls this week) and could result in a more decisive victory for the “out” faction in another round of elections this fall. Suddenly “Quitaly” was the new “Brexit.”
Trouble Ahead, Trouble Behind
The Mattarella tempest resolved itself just in time for markets to breathe a tempered sigh of relief and not pay attention to the no-confidence vote brewing over in Spain. The FSM/League coalition came back with an “acceptable” candidate for finance minister, Giovanni Tria (a political economy professor), Mattarella gave the green light, and all appears ready to proceed apace. Italian assets recovered some lost ground. The can appears safely kicked down the road once again, and now we can all relax and start watching the World Cup, right?
Perhaps not. There are challenges aplenty for this new, not entirely stable coalition government in Italy – on domestic debt levels, on immigration, and – yes – on the general relationship with Brussels, which is hardly amicable to begin with. And while observers don’t see much in the way of market ripples coming from the recent events in Spain, the fact remains that the no-confidence vote there came about due to revelations of political corruption and a slush fund operated by senior members of former PM Rajoy’s Popular Party – another blow to Establishment credibility. The new government led by the Socialists includes an unwieldly array of coalition partners including nationalist Basque and Catalonian factions and the far-left Podemos Party – so there is hardly a unifying ideology there.
In fact, very little about Europe’s political environment looks stable. Nationalist and borderline fascist blocs control much of the eastern periphery of the EU, Germany’s “grand coalition” is struggling, and all the while thorny issues with Brexit persist on the western front. The economy has reverted to slow-growth mode, the ECB is trying to navigate its way out of its monetary stimulus obligations, and now Brussels needs to rally the troops around a united response to those ill-advised US tariffs.
It may be summertime, but the living would appear to be anything but easy.
You may recall, dear reader, that there was a national election in Italy back in March that proved to be highly inconclusive. We’ll give ourselves a modest pat on the back for prognosticating ahead of that event its most likely outcome – a non-decision with power hanging in the balance as ascendant populist parties try to figure out a workable cohabitation while the previous center-left government – here as elsewhere throughout Europe – fades into oblivion. That election returned to occupy market attention this week.
Not This Time
The string of recent elections in Europe that started with the Netherlands and France around this time last year, and continued on into Germany last autumn, managed in each case to avoid a decisive populist surge into power while at the same time underscoring just how unpopular traditional parties there are – particularly those of the once-dominant center-left. At some point, the run of dumb luck was due to come to an end. That seems to have happened. It remains to be seen, though, whether the increasing likelihood of a government variously hostile or (at best) indifferent to the EU and the single currency will unnerve investors. Despite a bit of a hiccup on the Milan bourse (shown in the chart below) and a slight widening of the spread between Italian benchmark bonds and German Bunds, the answer so far is – not much.
Voi Volete Governare?
The question left pending after the March election was whether any such “workable cohabitation” for governing would be possible between the party platforms of the Five Star Movement (FSM) – the creation of a popular comedian, Beppe Grillo, the unifying message of which seems to be nothing more than “throw all the bums out” – and the more ideological Northern League, an ethno-nationalist party with roots in a movement for Italy’s prosperous north to secede from the rest of the country. As early as Tuesday this week that question appeared unresolved, and the chatter turned to the embarrassing possibility of a second election just months after the first.
Send In the Clown
Then, on Wednesday, the contours of Italy’s next government became clearer. Former prime minister and walking evidence for why the #MeToo movement exists, Silvio Berlusconi, gave his tacit blessing to a League-FSM governing union. Berlusconi’s own Forza Italia party underperformed in the March elections, but retained enough clout to give its still-politically viable leader a kingmaker role. The respective leaders of the League and the FSM, Matteo Salvini and Luigi di Maio, have instructed their key staff to reconcile platform positions by the end of the weekend. There is still the possibility that these will not bear fruit, but the consensus among insiders familiar with the process is that the next government of this G-7 nation will be run by a coalition decidedly at odds with Brussels on many important issues ranging from immigration to Eurozone fiscal policy to the need for sanctions against Russia (like many other European populist movements, both the FSM and the League are generally pliant towards Russia and Putin).
Nothing to See Here…Yet
There is a grain or two of rationality in the market’s relative complacency towards Italy. On the bond side, the ongoing presence of the ECB is a strong counterweight against wild fluctuations in yields. The central bank holds about 15 percent of the total float of Eurozone sovereign debt, which creates stability. The return to stagnation in the Eurozone economy (see last week’s commentary) reduces the likelihood that the ECB will move soon in any drastic way to curtail its QE program.
In equity-land, the large cap Italian companies that account for the lion’s share of total tradable market cap are largely multinationals with a diverse geographic footprint and thus less directly exposed to a potential economic downturn in their home market.
The current sense of calm notwithstanding, investors have long wondered whether a populist/nationalist government at the head of one of the major Eurozone nations poses a critical threat to the viability of the single currency region. An answer to that question, one way or the other, may be forthcoming in the months ahead.