Posts tagged Geopolitics & Markets
There are weeks when covering financial markets is interesting and engaging, where all sorts of macroeconomic variables and corporate business models demand analysis and discerning judgment for their potential impact on asset prices. And then there are weeks like this week, when none of those things seem to matter. “OMG Trump’s going to start a trade war and everything is going to be terrible” frets Ms. Market, just before the opening bell at 9:30 am. “No, silly, nothing’s going to happen, it’s just boys being boys, talking tough as always” say Ms. Market’s girlfriends while taking away her double espresso and offering some soothing chamomile tea instead. And so it goes, back and forth, up and down, day after tiresome day.
Soya Bean Farmers for Trump
We continue to believe that an all-out trade war between the US and its major trading partners is an unlikely scenario. But it has now been just shy of two months since the first announcement by the US administration of proposed new tariffs on steel and aluminum. The war of words, at least, shows no sign of fading into the background. Attention must be paid.
Moreover, the contours of the dispute have narrowed and hardened. Recall that the original steel and aluminum tariffs were comprehensive, drawing responses from all major trading partners. This week’s tough trade talk has been a much more bilateral affair between the US and China, starting with the formalization of $50 billion in new tariffs announced by the US on April 2. China promptly responded with its own countermeasures: $50 billion including major US exports like soya beans – a move that would go straight to the wallets of farmers in Trump-friendly rural America. Now here we are, on Friday morning, with the stakes raised to $100 billion after the latest US White House release. $100 billion represents about 20 percent of the total value of US imports from China. It would necessarily include many of the consumer products Americans buy – potentially suggesting a catalyst for higher inflation.
What Are Words For?
The message from the administration’s policy voices, such as they exist, to world markets has been essentially this: ignore our blustery words, they’re just harmless morsels of red meat for our rabid political base. All these tariff proposals, according to this line of thought, are just opening gambits for negotiation. Nobody really wants a trade war. This message was persuasive enough to bring Ms. Market out of her early morning funk on Wednesday. What was shaping up to be another one of those disheartening two percent-plus intraday plunges reversed course and finished north of one percent in the green column. We’ll see if the sweet talk is able to work its magic again today, with the S&P 500 back on the fainting couch during morning trading.
The other reason why markets may be inclined to not read too much into the playground tough talk is that actually executing a trade war would be far more complex than simply reading off lists of products and associated tariffs. The global economy truly is interlocked. What this means in practice is that trade is not anywhere nearly as simple as “China makes X, US makes Y and Germany makes Z.” Companies have invested billions upon billions of dollars in intricate value chains that start with basic raw inputs, go through multiple levels of manufacturing, wholesaling and retailing, and involve many different countries throughout the process. Dismantling these value chains, while theoretically possible, would result in an economy barely recognizable to the employees and consumers who have become used to them.
The earnings season for the first quarter is about to get underway, and it looks to be a barnstormer. FactSet, a research company, estimates that earnings per share for S&P 500 companies will grow around 17 percent year-over-year on average, which would make it the strongest quarter in more than 5 years (and, rationally, provide a nice tailwind for stock price valuations). The vast majority of these companies have absolutely no interest in being conscripted as foot soldiers in a trade war, and they will be sure to make their voices heard through plenty of influential lobbying channels. On the US side, at least, there is nothing remotely like a unified “team” suited up to do trade battle – and if they were to push the envelope further, they would almost certainly encounter more unity and clarity of purpose on the Chinese side.
In the end, the trade hawks in the administration may find a way to make do with a few cosmetic, harmless face-saving “wins” while quietly retreating from the battlefield. Meanwhile, though, we may have to put up with a few more of these irrational weeks in the market. Oh well. At least it’s springtime.
History is simply a collection of the biographies of great people, the charismatic heroes and anti-heroes whose supreme self-confidence, fanatical drive and decisiveness write the chapters of the ages. So believed Thomas Carlyle, the 19th century Scottish philosopher and historian who penned works on Napoleon, Frederick II of Prussia and a “Great Man Theory of History” in general.
Or, history is actually not that at all. History enslaves all humankind, great and small alike, to bit-player roles in a complexity of events, near-events and non-events that evolve in ways unfathomable and inaccessible to simplistic storytelling. So believed the great Russian writer Tolstoy, who devoted over 1,000 pages to a novel, War and Peace, to make this point.
To read War and Peace is to read of the cacophony of random events, missed communications, uninformed decisions and human behavioral traps that ultimately shaped events like the battles of Austerlitz and Borodino – not the genius of Napoleon, nor the resolve of Tsar Alexander I, but those thousands of probable and improbable things that had nothing to do with the supposed destinies of great men. “The tsar” wrote Tolstoy “is but a slave to history.” Outcomes have as much to do with weird supply-line hiccups, melting ice on river crossings and rioting prisoners as they do with those bold commands from the top generals.
Tolstoians Under Fire
Investment markets have been in a decidedly Tolstoian frame of mind for several years now. This view aligns with an understanding of the global economy as its own inscrutable, constantly evolving sea of complexity wherein rulers of nations and titans of industry float and bob like tiny specks on the surface. Geopolitical flare-ups happen; currency crises spring up in the Eurozone, citizens vote in seemingly irrational ways, but the global economy just keeps on keeping on. Real GDP keeps growing, corporate earnings grow even faster, job markets and consumer prices reassure us that there are no nasty recessions lurking around the corner. This mindset reached its high point in 2017, when volatility reached historically low levels no matter how crazy, dire or improbable the news of the day.
But this Tolstoian view has run into some stiff headwinds among investors in early 2018. There seems to be a newfound sense, among many, that humans vested with considerable power can, in fact, make consequential decisions that directly impact the value of portfolios of risk assets. The specific catalyst bringing out investors’ inner Carlyle is the growing threat of a trade war. Thursday’s reversal of 2.5 percent on major benchmark indexes was driven in large part by the latest show of bellicosity by the Trump administration and threats of retaliation by China, currently the primary intended target of a new round of punitive tariffs. Investors who were hoping for a quick V-shaped recovery from the original sell-off a few weeks ago can blame that original announcement of new tariffs on aluminum and steel for cutting off the nascent recovery in share prices.
Great (by which we mean “vested with lots of power,” not to be confused with “good”) leaders making bad decisions: a Carlyle-esque reprise of that ill-fated summer of 1914? Or, ultimately, a brief tempest that sooner or later will fall back into an inconsequential ripple on the ever-expanding sea of the global economy? Your own view of markets in 2018 may well be shaped by whether you are more inclined to agree with Carlyle or with Tolstoy.
The Corporate America Variable
If Trump and his inner circle continue to raise the stakes on a trade war, they will be due for an earful from many corners of Corporate America for whom such an outcome is the very opposite of their business growth models. S&P 500 corporations derive in the aggregate more than half their revenues from outside the US. Almost any major company that produces a good or service with a viable market in China is focused on that market for a considerable amount of its potential future growth. This doesn’t just apply to the obvious names of retailers like Starbucks, Nike and Yum! Brands that have been in that market for years, but to firms in any industry from property & casualty insurance to pediatric nutrition to semiconductors. Sure, steel producers may cheer the prospects for protective tariffs in the short run, but their collective market cap weight is considerably less than that of those who forcefully champion more open trade.
So what will it be? Is the global economy, the creation of millions of random interactions of events and non-events and near-events over the past four decades, destined to simply keep evolving, too massive and too necessary in its current form for a sudden reversal into autarkic nation-states waging economic war on each other? Our general inclination is to take a Tolstoian view of things, and we think it likelier than not that the threat of $60 or even $100 billion in punitive tariffs and associated bellicose posturing will not have the power to topple a global economy worth more, in nominal GDP, than $85 trillion.
That is not to say that we have a Panglossian “best of all possible worlds” take on things. Tolstoy never said that history always works out for the best. Sometimes those random, incoherent things that happen or that don’t happen lead to unhappy outcomes – see 1914, 1917 and 1933 as examples of this in the last century. Disciplined investing requires keeping emotions in check, but it also requires us to not rule out improbable, but possible, scenarios.
Longtime readers of our research and commentary know that we spend quite a bit of time dwelling on the economic metric of productivity. Our reason for that is straightforward: in the long run, productivity is the only way for an economy to grow in a way that improves living standards. Curiously, the quarterly report on productivity issued by the Bureau of Labor Statistics generally fails to grab the kind of headlines the financial media readily accord to unemployment, inflation or GDP growth. So there is an excellent chance that today’s release showing a drop of 0.1 percent in productivity growth for Q4 2017 (and a downward revision for the Q3 number) didn’t show up in your daily news digest. And while one quarter’s worth of data does not a trend make, the anemic Q4 reading fits in with a larger question that bedevils economists; namely, whether all the innovation bubbling around in the world’s high tech labs will ever percolate up to deliver a new wave of faster growth.
Diminishing Returns or Calm Before the Wave?
The chart below shows the growth rate of US productivity over the past twenty years. A burst of relatively high productivity in the late 1990s and early 2000s faded into mediocrity as the decade wore on. After the distortions (trough and recovery) of the 2007-09 recession, the subsequent pattern has for the most part even failed to live up to that mid-2000s mediocrity.
There are two main schools of thought out there about why productivity growth has been so lackluster for the past 15 years. The first we could call the “secular stagnation” view, which is the idea that we have settled into a permanently lower rate of growth than that of the heyday of 25 years or so following the Second World War. The second school of thought is the “catch-up” argument, which says that scientific innovations need time before their charms fully work their way into the real economy. Readers of our annual market outlooks may recall that we closely examined the secular stagnation argument back in early 2016, while the catch-up philosophy occupies several pages of the 2018 outlook we published last week.
The most persuasive evidence made by the catch-up crowd is that both previous productivity waves – that of the late ‘90s – early 00s shown in the above chart and the longer “scale wave” that ran from the late 1940s to the late 1960s – happened years after the invention of the scientific innovations that powered them. Most economists ascribe a significant impact to the products of the Information Age – hardware, software and network communications – in explaining the late 1990s wave. But those products started to show up in business offices back in the early 1980s – it took time for them to make an actual impact. According to this logic, it should not be surprising that the potentially momentous implications of artificial intelligence, deep machine learning, quantum computing and the like have yet to show that they make a real difference when it comes to economic growth.
Productivity and Inflation
The economic implications of productivity tend to be longer term rather than immediate – that is probably why they don’t merit much coverage on the evening news when the BLS numbers come out. After all, the economy is not going to stop growing tomorrow; nor will millions of jobs disappear in one day if another productivity wave comes along with the potential to make all sorts of service sector jobs redundant (a point we make in our 2018 outlook if you’re interested). The lack of immediacy can make productivity debates seem more like armchair theory than like practical analysis.
But productivity (or its lack) does have a lot to do with a headline number very much in the front and center of the daily discourse: inflation. What the BLS is reporting in the chart above is labor productivity: in other words, the relationship between how much stuff the economy produces and how much it costs to pay for the labor that produces that stuff. If compensation (wages and salaries) goes up, while economic output goes up by a smaller amount, then effectively you have more money chasing fewer goods and services – which is also the textbook definition of inflation.
In fact, the BLS notes in its Q4 productivity release that higher compensation was indeed the driving factor behind this quarter’s lower productivity number. Bear in mind that unemployment is currently hovering around the 4 percent level (this is being written before the latest jobs report due out Friday morning), and anecdotal evidence of upward wage pressures is building. An upward trend in unit labor costs (the ratio between compensation and productivity) has the potential to catalyze inflationary pressures.
Keep all this in mind as we watch the 10-year Treasury inch ever closer towards 3 percent. As we noted in our annual outlook, it makes sense to watch the bond market to understand where stocks might be going. And anything related to inflation bears close monitoring to understand what might be happening in the bond market.
And the band plays on. Some random convergence of factors could conceivably interrupt and reverse today’s upward push in the S&P 500 before the benchmark index ends with its seventh straight record close…but those would likely be bad odds to take. Yesterday was the 30 year anniversary of 1987’s Black Monday, when stocks tanked by more than 20 percent in a single day. Financial pundits, with not much better to do, spent much of the day in college dorm-style bull sessions with each other, speculating about whether 10/19/87 could ever happen again. It certainly didn’t happen yesterday, even though lower overnight futures injected a frisson of excitement into the morning chatter that dissipated as the afternoon yielded a predictable recovery and small gain for share prices.
We feel for those journalists – it’s tough being a financial commentator these days! Nothing ever happens except for the market shrugging off any potentially disruptive event, while displaying brief spasms of ecstasy whenever the subject of tax cuts percolates to the top of the daily news feed. Now the chatter is homing in on what may well be the only remaining story of any note (from the market’s perspective) before the end of the year: the identity of the new Fed chair when Janet Yellen’s term ends next January. A decision is supposedly forthcoming in the next couple weeks (the incumbent administration suggests it will be before November 3). Our sense is that, regardless of who among the short-listed candidates is tapped, the impact on markets will likely be negligible.
If It Ain’t Broke…
There are two issues at stake here: first, who the winning candidate will be, and second, how that candidate would actually govern once ensconced in the Eccles Building. There are currently five names under consideration. On a spectrum from dove to hawk they read as follows: current Fed governor Jerome (Jay) Powell, current Fed chair Janet Yellen, former Fed governor Kevin Warsh, Stanford University economist John Taylor, and current Trump advisor Gary Cohn. Let’s say right off the top that we see next to no chance that Cohn will draw the winning ticket; among insiders close to the decision process, his name appears to still be in the mix for cosmetic reasons only.
That leaves four. Two, Powell and Yellen herself, reliably fall into the camp of “stay the course” – their votes on FOMC policy decisions, after all, are publicly documented and widely known. Speculation this week has Powell as the overall front-runner with considerable support both from the administration’s inner circle and among both Republican and Democratic senators who will be involved in the confirmation process. There would be a rational logic for Trump to ultimately thumbs-up Powell: in so doing, he would be making the safest choice for business as usual, while still getting to theatrically crow to his base that he dumped the Obama-era Fed head.
…Don’t Fix It
Just because Powell’s star seems ascendant this week, though, does not mean that the two more hawkish choices of Warsh or Taylor are out of the picture. This is not an administration known for predictably rational decision making. So what happens then? Speculation is particularly focused on John Taylor, the Stanford professor whose “Taylor rule” – a mathematical formulation of the responsiveness of interest rates to inflation and other economic inputs – suggests that rates should currently be higher than they are. Would a Taylor Fed necessarily mean a dramatic acceleration of rate hikes and attendant balance sheet normalization?
Perhaps not. It’s worth remembering that a Taylor Fed would be looking at the same data as the Yellen Fed, and that data include inflation readings, the danger-zone indicators of which are conspicuously absent. The Taylor rule is not immune to the inflation conundrum with which the Fed’s other analytical models have struggled. It’s also worth remembering that the Fed chair still has to take into account the positions of the other FOMC voting members. Whoever the new chair is, he or she will not be any less interested in building consensus towards unanimous decisions than past chairs. That’s how stable monetary policy is conducted.
The global economy is largely in sync with low to moderate growth, decently functioning labor markets and modest levels of inflation. That’s the real context in which stock prices can keep drifting up with no sizable upside headwinds. We think it is unlikely that, come 2018, a new Fed will be tempted to push their luck with policies that could choke off the growth before its time. For these reasons we think it unlikely that the identity of the new Fed chair will stand in the way of a business-as-usual mood in the market that, barring something currently unforeseen, could carry into and through the upcoming holiday season.
Gentle reader, please indulge us our seeming obsession with the subject of inflation. Yes, we know that other macro metrics matter as well, but inflation is both the big mystery – as we discussed in last week’s column – and arguably the heavy hand pushing and pulling the market to and fro. Today we focus more on this “actionable” aspect of inflation. Or, to perhaps be more precise, we focus on the curious case of a market with the stars of an imagined reflationary surge sparkling in its eyes – in the very same week when yet another month’s reading informs us that a pick-up in inflation is nowhere to be seen in the real world.
Not Dead Yet
It really doesn’t take much, even after all this time. The so-called “reflation-infrastructure trade,” which financial pundits necessarily rebranded as the “Trump trade,” died an unofficial death back in the first couple months of the year. That’s about the time when the US dollar swooned at the feet of a soaring euro and Aussie dollar, and value stocks in sectors like financials and energy ceded the high ground to their growth counterparts in tech.
But 2017 is, if nothing else, the year of endless lives, whether it be multiple attempts to repeal and replace healthcare policy or the renewed insistence that hypergrowth-fueled inflation is just around the corner. “The Trump Trade Is Back!” screamed Bloomberg News on Wednesday, joined by a chorus of like headlines from Yahoo! Finance, Business Insider and others. Once again financial institutions and resource companies were the market darlings. Bond yields perked up. Even the beleaguered dollar took a victory lap or two. Mr. Market was ready to party like it’s late 2016.
A Framework of an Outline of a Plan
The catalyst for this week’s effervescence, of course, was the release on Wednesday of a tax reform framework. It wasn’t really a plan, because plans generally contain details about specific sources of revenues and costs over a defined time frame, grounded in plausible assumptions. The major assumption made by the authors of this framework is that it will somehow deliver anywhere from 3 to 6 percent (depending on whom in the administration you care to believe) in long-term sustainable growth.
Now, given that we have not experienced real GDP growth of that caliber for many decades, it would be reasonable to believe that a boost of that magnitude would beget more inflation, hence higher interest rates, hence the improved fortunes of banks and oil drillers and the like. Unfortunately for the credibility of the proposal’s framers, the plausibility of sustained growth at those levels is vanishingly low. The Fed’s median estimate of US long-term growth potential is 1.8 percent. Earlier this year the Congressional Budget Office estimated that if all the fiscal stimulus measures proposed at one time or another by the new administration (tax reform, infrastructure spend and all the rest) were successfully implemented, it could add one tenth of one percent to long term growth. So the Fed’s 1.8 percent would become 1.9 percent, hardly reason to break out the Veuve Cliquot.
Back in the Real World
Meanwhile Friday morning delivered yet another Debbie Downer data point to the market’s Pollyanna. The personal consumption expenditure (PCE) index, the Fed’s preferred inflation measure, came in for the month of August below consensus expectations at 0.1 percent. That translates to a 1.3 percent year-on-year gain, matching its lowest level for the past five years and well below the Fed’s elusive 2 percent target. We imagine this reality will likely show up again soon enough in the bond and currency markets (which also were the first to ditch the Trump trade back in February). But the stock market is a different animal. Is there enough wishful thinking to keep the reflation trade alive long enough to get through the tricky month of October and into the usually festive holiday trade mindset? Perhaps there is – money has to go somewhere, after all. At some point, though, reality bites back.