Posts tagged Market Impact Events
Pundits who follow financial markets are always ready to supply a narrative to the crisis of the day. “Stocks fell today because of X” is how the story usually goes, although “X,” whatever it may be, is likely only a strand of a larger fabric. These days market-watchers are focused on Turkey, and the “X” factor giving the story a human face is one Andrew Brunson, a North Carolina pastor who for the past two decades or so has lived in Turkey, ministering to a small flock of Turkish Protestants. Brunson was caught up in a 2016 political backlash following an attempted military coup, and has been detained on charges of collaboration (unfounded, he claims) against the Erdogan regime ever since.
Earlier this month the Trump administration anticipated Brunson’s release after protracted negotiations. Instead, the pastor was placed under arrest. The US responded with a new round of sanctions, including a 50 percent levy on imported steel. Team Erdogan dug its heels in. The currency collapsed and – voila! – the summer of 2018 now has its official crisis. For investors, the pressing question is whether this is an isolated event, or a larger peril with the potential to turn into a 1997-style contagion.
Shades of 1997
Once seen as the next likely candidate to join the European Union and pursue the traditional path to prosperity by linking in to the global economy, Turkey instead has become a dictatorship under Erdogan. Possessed of a less than perfect understanding of macroeconomics, Erdogan has doggedly refused to address the country’s currency crisis by raising interest rates, the normal course of action. Facing down external borrowing needs of $238 billion over the next twelve months, the regime improbably imagines relief coming from comrades-in-arms such as China, Russia and Qatar. These are Turkey-specific problems.
But currency woes are anything but local-only. Almost all major emerging markets currencies are having a terrible time of things in 2018. The chart below shows four of them, including the Turkish lira.
From this standpoint, the situation looks less like a simple tempest on the Bosphorus, and more like the summer of 1997. That was when Thailand, under speculative attack from foreign exchange traders, floated its currency and sparked a region-wide cataclysm of devaluations and stock market collapses. One of the issues contributing to the mess in 1997 was the vulnerability of countries with large amounts of dollar-denominated external debt – a falling currency makes it increasingly difficult to service interest and principal payments on this debt.
This is an issue of relevance today as well; indeed, countries with the largest non-local debt exposures have been hit hardest alongside the lira (see, for example, the South African rand in the above chart). Another theme of 1997 was current account deficits, a particularly important data point for countries where exports play a central role in growth strategies. That has been the driving force behind India’s currency woes this year (also shown above). High oil prices (a key import item) have raised India’s trade deficit to its highest level in five years. And, of course, the specter of a trade war looms over all countries active in global trade.
Sleepless in Shanghai
Arguably the biggest difference between 1997 and today is the role of China in the world’s economy. Back then the country was still in the early stages of the boom that spawned the great commodities supercycle of the 2000s. Now it is the world’s second-largest economy (and the largest when measured in purchasing power parity terms). China is currently dealing with its own growth challenges – very different from those facing trade deficit-challenged economies like India or near-basket cases like Turkey, but concerning nonetheless. The Shanghai and Shenzhen stock markets have been in bear market territory for much of the summer. China’s biggest challenge is managing the transition of its economy from the fixed investment and infrastructure strategy that powered those supercycle years into a more balanced, consumer-oriented market. That is the right thing to do – the infrastructure approach is not sustainable for the long term – but concerns about the transition persist even while the country putatively continues to hit its GDP growth targets.
So how much contagion risk is there? The main problem as we see it is not that the detention of a pastor in Turkey could bring down the global economy. It is that all these strands – debt exposures, trade deficits, growth concerns, trade war rhetoric – are percolating to the surface at the same time. The story is not as systemic as that of the ’97 currency crisis, where the same one or two problems could be ascribed to all the countries suffering the drawdowns. But with all of these strands front and center at the same time, we cannot rule out the potential for broader repercussions.
The ’97 crisis had only a limited impact on developed markets. US stocks paused only briefly before resuming their manically bullish late-1990s ways. So far, neither turmoil in Turkey nor sleepless nights in Shanghai are having much impact on things here at home. A little more volatility here and there, but stocks within striking distance of January’s record high for the S&P 500 (and still setting new highs when it comes to NASDAQ). But we’re closing in on the always-important fourth quarter, and need to be fully cognizant of all the different narratives, positive and negative, competing for attention as the lead theme.
It’s been one of those weeks where a virtual hailstorm of headlines overwhelms the normal mechanics of cognitive functioning. So much so, that one could easily turn one’s attention away from China for a brief second and turn it back to find that the currency has plummeted in a manner eerily similar to that of August 2015. The chart below shows the path of the renminbi over this time period, along with the concurrent trend of the Shanghai Composite stock index.
Remembrance of Shocks Past
In the chart above we highlight the two “China shocks” that rippled out into global markets in 2015 and 2016. The first was a sudden devaluation of the renminbi in August ’15, a move that caught global investors by surprise. The domestic China stock market was already in freefall then, but the currency move heightened broader fears of an economic slowdown and eventually pushed the US stock market into correction territory.
The second China shock happened just months later, when a raft of negative macro headlines greeted investors at the very start of the new year. Another global risk asset correction ensued, though the drawdown was relatively brief.
Considering those past shocks, though, investors are reasonably concerned about the implications of this week’s moves in both the renminbi and Chinese equities – which briefly entered bear market territory earlier this week. Pouring fuel on the flames, of course, is the addition of an X-factor that wasn’t present for the previous shocks – the looming presence of a potential trade war. Coupled with renewed concerns about China’s growth prospects – with or without a trade war – there is a strong sense in some camps that a third China shock may reverberate out into the global markets.
Less Is More
We understand the concerns, particularly as they are far from the only news items creating a general sense of uncertainty in the world. But our sense is that China’s growth troubles are actually good – good for the country and ultimately good for the global economy. What has slowed down in China this year – well, ever since last autumn’s Communist Party Congress, in fact – has been leveraged fixed asset investment. This is where state-owned enterprises raise copious amounts of debt and invest in infrastructure and property development projects for the primary (seemingly) purpose of beefing up the headline GDP number.
Beijing’s economic authorities have been trying to rebalance the economy away from these repeated trips to the borrow-and-build trough since 2014, but the turbulent domestic financial market conditions of 2015-16 weakened their resolve. The deleveraging commitment got a new breath of life with President Xi Jinping’s consolidation of power after last October’s party congress. With little to worry about politically, Xi and the party formalized the model of “quality over quantity” in the growth equation. So while fixed asset investment and borrowing have slowed considerably, consumer spending has increased. The service economy is growing as a percentage of overall GDP. In the long term, this is a more sustainable model for the world’s second largest economy than unwise lending for the construction of bridges to nowhere.
The Trade Factor
Yes, but what about the trade war? Well, it’s true that uncertainty about the future of trade in general is a clear and present factor in the state of world markets. The unnerving headlines seem unlikely to go away any time soon – the latest today being Trump’s apparent intention to take the US out of the World Trade Organization (without really understanding what that organization is or how, legally, the US would untangle itself from the organization that is the successor to the General Agreement on Tariffs and Trade framework the US itself architected at the Bretton Woods meetings of 1944).
We haven’t had a global trade war since the 1920s, though, so while it is certainly possible to model alternative scenarios, there’s not much in the way of actual data to support persuasive analysis of potential winners and losers. In the meantime, as regards China, the recent patterns in the stock and currency markets merit some concern, but the underlying story is not as negative as some of the present day commentary would suggest.
Investors price a variety of assumptions into their asset valuation models every day, based on cyclical factors like interest rates and inflation expectations. Behind all these short term variables, though, is a more fundamental assumption about how the world works. That assumption is grounded in the primacy of what, for want of a better phrase, we call the “global technocracy.” As well it should be – the technocracy has survived largely intact since the Bretton Woods conference of 1944 that set the postwar world order.
But the global technocracy is in trouble, and we don’t really have a good playbook for mapping out scenarios involving their eclipse by other forces. This may prove to be interesting times – in the sense of that old Chinese proverb – for analysts trying to distill tectonic shifts in the macro world order into an informed model of likely asset price trends.
Saving the World, One Crisis At a Time
The global technocracy is made up of the policymakers – central bankers, finance ministers and their ilk – who can always be counted on to steer markets away from the shoals of peril back into calmer seas. They may not necessarily solve the problem of the day, but they can paper it over for a later day. Think of the Greek debt crisis and the various US debt ceiling debacles in recent years, and the bailout of the Long Term Capital Management hedge fund in the late 1990s. Back then we had the “Committee to Save the World” as Time magazine dubbed the triumvirate of Alan Greenspan, Robert Rubin and Lawrence Summers. In our present day we have Mario “Whatever It Takes” Draghi and of course the now-technocrat emeriti team of Ben Bernanke and Janet Yellen who got us safely through the narrows of Scylla and Charybdis and back to growth after the Great Recession.
Stop Us If You’ve Heard This One Before
“They won’t pay their fair share!” “It’s time to put America, and working Americans, first!” “No more bad trade deals!” Sounds familiar, right? As in literally every day of life since January 2017. Please don’t think of this as anything unusual or unprecedented. Think, instead, of 1920. The Great War had ended, and our European allies, battered and destitute, owed America $10 billion in reparations for war debts (about $152 billion in present-day terms). World War I put an end to a glorious 40-year era of global technocracy, led by Great Britain.
With Britain severely weakened, the mantle of leadership now fell to the US. The major private investment interests of the day, led by the likes of J.P. Morgan and A.J. Drexel – card-carrying members of the global technocracy – saw the war debts as an albatross that would impede the ability of their European trading partners to return to commercial viability, and they argued for cancelling them. Their arguments – and those of the Europeans themselves – fell on deaf ears in Washington. The Republican Party that came to power in 1920 was highly protectionist and inclined to…well, put America first. Not only did the US insist on full reparation of war debts, but Congress enacted highly punitive protectionist tariffs in 1921 and 1922. They would follow this, of course, with the extreme measures of the Smoot-Hawley tariffs in 1930.
The global technocracy was out. Narrow-interest protectionism was in. How did that work out?
A Splendid Little Decade, Until…
Actually, it worked out splendidly…for quite a number of years. That decade, of course, went down in history as the “Roaring Twenties.” It was an era of rapid technological advancement. The modern production-line factory came of age. Radio and wireless communications made RCA an early prototype for dot-com and then “FAANG” mania. Retail outlets and catalogue merchandisers such as Sears and Woolworth’s streamlined their business models. Prosperity abounded.
It all came to a dismal end, of course, with the 1929 market crash and the Great Depression. America’s aggressive economic stance against its allies (“trench warfare by other means” as the cynics of the day termed it) hindered reconstruction in Europe and left a leadership vacuum all too happily filled by opportunistic political extremists on the Continent. It would take another war, even more brutal and destructive than the first, for America to willingly accept its role as economic superpower and de facto head of the global technocracy.
It’s All About the Timing
The moral of this story is quite simple. While we may indeed be on the cusp of another tectonic shift in world affairs – in which narrowly partisan self-interest once again pushes the global technocracy off center stage – there is no real playbook to instruct as to how and when asset markets will react accordingly. A thoughtful investor in 1920 would have had excellent arguments, based on the data available at the time, to go all cash. That investor would have been right…nine years and 240 percent of cumulative stock price appreciation later.
It’s all about the timing. In the absence of a good playbook, investors and prognosticators are likely to learn just how tricky that can be. Think about this, though, at those barbeques this summer when some know-it-all tries to tell you that the sky is falling and it’s time to get out. Or that you should double down, because we’re about to embark on the most prosperous age ever known to humankind. “If X, then Y” is how the pundits like to spin their arguments into gold. The more salient formulation, though, is “If X, WHEN Y?” And that’s a question with an exceedingly elusive answer.
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.
We’ve sort of gotten into the habit of referring to the 2018 equity market pullback in the past tense, which is not technically correct as the S&P 500 still languishes around 7 percent below its late-January record high. But the sense of drama that accompanied those big plunges in February in March, alongside the breathless narrative of a global trade war, is no longer clear and present. Is it too early to do a post-mortem and contemplate what may lie ahead? That’s entirely possible – whatever the market decides to do on May Day and the rest of next week is as murky as always. Nonetheless, we have our forensic tools out and will do a little dissecting of the present state of things. As volatile as things have been, this has so far been a remarkably well-behaved little correction.
Highly Relevant Nonsense
Perhaps nowhere is this well-tempered aspect more visible than in the market’s price performance vis a vis its technical moving averages, particularly the 50-day and 200-day averages. Now, we have made the point before and we will make it again: there is nothing magical or transcendental about moving averages. They are just methodical calculations. But they are given relevance because short-term trading strategies make them relevant – another example of the “observation affects reality” phenomenon we have described in other recent commentaries. The chart below shows the year-to-date performance of the S&P 500 along with the 50- and 200-day averages, and also the yield on the 10-year Treasury (which we will discuss in further detail below).
The 200-day moving average often serves as a support level. Technical traders get worried when the market breaches this downside support and fails to reestablish a position above it. No such worries this time: the index breached the 200-day average a handful of times in intraday trading but only closed once below it. Enough of those algo strategies were wired to kick in at this level, and there wasn’t enough prevailing negative sentiment to push prices into further negative territory. This played out most recently during this past week.
Our takeaway message from this is more or less what we’ve been saying throughout this period; namely that the catalyzing X-factors of this pullback – first the inflation fears after the February jobs report and then the new US tariffs – weren’t convincing enough to detract from the background narrative of continuing global growth and healthy corporate earnings.
On the other hand, though, the S&P 500 has had a similarly hard time staying above the resistance level of the 50-day moving average. Sentiment then, while not bearish, is also not wildly bullish. Investors wanting to see a clear “W” shape emerging from the pullback may have to bide their time for a while longer, or at least until the momentum strategy funds that got burned in February have worked through all their pain trades and those moving averages become less relevant to the daily flow of things.
Stocks and Bonds: Not Quite a Pas de Deux
Another observation that’s done a few laps on the financial pundit circuit recently is the idea that stock prices and bond yields have been moving in the same direction for much of the year. Well, sort of. In the aggregate that observation is clearly not true: stock prices are struggling to break even for the year to date, while the 10-year Treasury yield is up sharply from where it was in early January. But the chart above does show some degree of correlation during different sub-periods, most especially in the first three weeks of January when they did seem to move almost in tandem. Yields also reverted to traditional safe haven behavior during the second (trade war) prong of the pullback in mid-late March.
The correlation pattern diverged more prominently during the S&P 500’s mini-retreat of late last week and the first half of this week. The 10-year yield spiked to puncture the 3 percent level for the first time since 2014. Meanwhile, stocks fell back as investors, digesting a healthy stream of corporate earnings, did their best impression of a bratty kid who didn’t get the exact Christmas present he was expecting. “Peak quarter” seems to be the phrase of the day: the idea that this is about as good as it will get, even though the hard evidence for that glass half empty conclusion appears sparse.
What’s the overall takeaway? There’s a whiff of 2015 in the air. In that year stock prices set a record high in May and didn’t break new high ground until June of the following year (ironically, in the immediate aftermath of the Brexit vote, go figure). Cautious sentiment – neither pessimistic nor optimistic – may keep share prices in a sideways pattern. Those silly moving averages may continue to restrain directional breakouts. This kind of environment often suggests a return to quality, where things like free cash flow and debt ratios actually matter again and careful stock selection can pay off.
Then again, none of that could be true. If there’s anything one learns over the days and years in this profession, it is to always expect the unexpected.