Posts tagged Risk
If you have paid any attention to the daily dose of financial media chatter over the past month or so (and we are of the firm opinion that there are many, many more productive ways to spend one’s time) you have no doubt come into contact with the phrase “flat yield curve.” If the phrase piqued your interest and you listened on, you would have learned that flat yield curves sometimes become inverted yield curves and that these are consistently accurate signals of imminent recession, going back at least to the beginning of the 1980s.
This topic is of particular interest today because the yield curve happens to be relatively flat. As we write this the spread (difference) between the 10-year Treasury yield and the 2-year Treasury yield – a common proxy for the yield curve – is just 0.25 percent. That is much tighter than usual. In fact the last time the yield curve was this flat was in August 2007 – and any financial pundit worth his or her salt will not hesitate to remind you what happened after that. The chart below diagrams the longer-term relationship between 10-year and 2-year Treasury yields going back to 1995.
Before the Fall
In the above chart we focus attention on two previous market cycle turns where a flat or inverted curve was followed by a recession and bear market environment: 2000-02, and 2007-09. It is true that in both these instances a recession followed the flattening of the curve (the red-shaded columns indicate the duration of the equity market drawdown). But it’s also important to pay attention to what happened before things turned south.
Both of these bear market environments were preceded by an extended period of growth during which the yield curve was also relatively flat. These “growth plus flat curve” periods are indicated by the green-shaded columns in the chart. As you can see the late 1990s – from about mid-late 1997 through the 2000 stock market peak – were characterized by very little daylight between the 2- and 10-year yields. The same is true from late 2005 through summer of 2007 (the S&P 500 peaked in October 2007 before starting its long day’s journey into night).
You Can Go Your Own Way
In both of those prior cases, in other words, a flattening yield curve wasn’t a signal of very much at all, and investors who took the cue to jump ship as soon as the spread went horizontal missed out on a considerable amount of equity market growth. In fact, the dynamic of “flat curve plus growth,” far from being unusual, is not unexpected. It has to do with what the respective movements of short term and long term yields tend to tell us about what’s going on in the world.
Short term rates are a much more accurate gauge of monetary policy than yields with more distant maturities. If bond investors anticipate an upcoming round of monetary tightening by the Fed, they will tend to move out of short-term fixed rate securities, sending yields on those securities higher. When does monetary policy normally turn tighter? When growth is heating up, of course – so it should be no surprise that short term rates will start trending up well before the growth cycle actually peaks.
Longer term yields, on the other hand, are much less predictable and tend to go their own way based on a variety of factors. For example, in that 2005-07 period when short term rates were trending up, the 10-year yield stayed relatively flat. Why? Because this period coincided with the height of China’s “supercycle” during which Beijing routinely bought gobs of Treasury bonds with its export earnings, building a massive war chest of dollar-denominated foreign exchange reserves.
To Every Cycle Its Own Story
At the same time, many other central banks were building up their FX reserves so as to not repeat the problems they experienced in the various currency crises of the late 1990s. Yes – the late 1990s, when economies from southeast Asia to the former Soviet Union to Latin America ran into liquidity difficulties and injected a massive amount of volatility into world markets. Global investors responded to the volatility by seeking out safe haven assets like – surprise! – longer-dated US Treasury bonds. Which partly explains why the yield curve was so flat from ’97 through the 2000 market peak.
So yes – at some point it is likelier than not that we will see another flat-to-inverted yield curve lead into another recession. Meanwhile, the dynamics driving longer-term bond issues today are not the same as the ones at play in the mid 2000s or the late 1990s. Maybe spreads will widen if a stronger than expected inflationary trend takes root. Maybe the 10-year yield will fall further if US assets are perceived to be the safest port in a global trade war storm. The important point for today, in our opinion, is that there is a resounding absence of data suggesting that this next recession is right around the corner. We believe there is a better chance than not for some more green shading on that chart between now and the next sustained downturn.
The financial news headlines on this, the first Friday of the second half of 2018, seem fitting. Appropriately contradictory, one might say, providing a taste for what may lie ahead in these next six months. First, we have news that Donald Trump’s splendid little trade war is happening, for real now! Tariffs have been slapped on the first $34 billion worth of products imported from China. On the other side of the ledger, an American ship full of soya beans was steaming full-on to reach the Chinese port of Dalian in time to offload its supply before facing the retaliatory tariffs mandated from Beijing. Too bad, so sad, missed the deadline. Apparently the fate of the ship, the Peak Pegasus, was all the rage on Chinese social media. The trade war will be Twitterized.
The second headline today, of course, was another month of bang-up jobs numbers led by 213K worth of payroll gains (and upward revisions for prior months). Even the labor force participation rate, a more structural reading of labor market health, ticked up (more people coming back into the jobs pool is also why the headline unemployment rate nudged up a tad from 3.8 to 4.0 percent). Hourly wages, a closely followed metric as a sign of potential inflation, recorded another modest year-on-year gain of 2.7 percent.
So there it is: the economy continues to carry on in good health, much as before, but the trade war has moved from the theoretical periphery to the actual center. How is this going to play out in asset markets?
Manufacturers Feel the Pain
The products covered by this first round of $34 billion in tariffs are not the ones that tend to show up in Wal-Mart or Best Buy – so the practical impact of the trade war will not yet be fully felt on the US consumer. The products on this first list include mostly manufacturing components like industrial lathes, heating equipment, oil and gas drilling platform parts and harvester-thresher combines. If you look at that list and think “Hmm, I wonder how that affects companies like Caterpillar, John Deere and Boeing” – well, you can see for yourself by looking at the troubled performance of these companies’ shares in the stock market. As of today those components will cost US manufacturers 25 percent more than they did yesterday. That’s a lot of pressure on profit margins, not to mention the added expense of time and money in trying to figure out how to reconfigure supply chains and locate alternative vendor sources.
Consumers Up Next
The question – and probably one of the keys to whether this trade war inflicts real damage on risk asset portfolios – is whether the next slates of tariffs move from theoretical to actual. These are the lists that will affect you and me as consumers. In total, the US has drawn up lists amounting to $500 billion in tariffs for Chinese imports. In 2017 the US imported $505 billion from China – we’re basically talking about the sum total of everything with a “Made in China” label on it. Consumers will feel the pain.
If it comes to pass. The collective wisdom of investors today has not yet bought into the inevitability of an all-out trade war. US stocks are on track to notch decent gains for this first week of the second half. The job numbers seem to be holding the upper hand in terms of investor sentiment. Sell-side equity analysts have not made meaningful downward revisions to their sunny outlook for corporate sales and earnings. Sales for S&P 500 companies are expected to grow at a rate of 7.3 percent this year. That reflects an improved assessment from the 6.5 percent those same analysts were projecting three months ago – before the trade war heated up. The good times, apparently, can continue to roll.
Since we haven’t had a global trade war since the 1920s, we can’t model out just how these tariffs, in part or in full, will impact the global economy. Maybe the positive headline macro numbers, along with healthy corporate sales and profits, can power through this. Perhaps the trade war will turn out to be little more than a tempest in a teapot. We may be about to find out.
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.
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.
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.