May You Live In Interesting Times

The December equity meltdown saw most equity investors throw in the towel. Our WMA U.S. Composition Market Risk Indicator indeed fell into the capitulation zone. Everyone who had fears of the Fed Equity Bubble popping sold their holdings. Fund managers took defensive action to raise cash and/or hedge positions. As a result, it is not that surprising to see equities completing four consecutive positive weekly gains. The S&P 500 is now about +14% above the December 24 low. Once everyone got leaning the wrong way in December, markets did what was needed to ensure that the maximum number of investors either lose money, are forced to buy in at higher prices, or sit out and watch equity prices climb without them. Even if fears of recession were overblown in December, we remain dubious that whatever time and additional growth is left in the current economic expansion will be sufficient to push U.S. equity indexes back to 2018 highs.

Many of the government-produced macroeconomic statistics were delayed this week due to the government shut-down. Among the data that we did see, most went in favour of seeing a more patient Federal reserve. Empire Manufacturing (New York PMI) slide to 3.9 in January from 11.5 the prior month, weekly jobless claims came in below forecast, and industrial production fell from the prior month. The Philly Fed Index, however, was stronger in January (17.0 vs 9.1 in December). Price data also added to the argument of no more Fed rate hikes for the foreseeable future. Producer prices fell -0.2% in December (below the -0.1% expected) and import prices slipped -1.0% in December. We will be watching closely the ISM PMI the first week of February. Although December’s reading remained in expansion territory, we saw a significant deceleration. If the deceleration trend continues, equities will likely roll over again.

Interesting Times Rhyme With Bewildering Times

The old Chinese proverb, “may you live in interesting times”, while interpreted in a positive sense by Westerners, is in fact a Chinese curse. For many investors, the excesses seen over the past 10 years, from the Financial Crisis melt-down in 2008-2009 to the Central Bank Bubble melt-up from 2012-2018, have been more bewildering than interesting. Especially from the perspective of portfolio performance.

Markets have definitively forgotten about the debt problems in the economy that provoked the Financial Crisis, even if the debt levels have only growth since 2008. We know that debt levels, especially corporate debt levels, stoked by 0% interest rates for most of the past 9 years, will at some point bring about the day of reckoning. However, portfolios must be managed in the short-run, keeping in the back of the mind this long-term risk.

As for the Federal Reserve, markets had a period of doubt in December (after the Fed’s FOMC meeting) whether or not the Fed still “had our backs”. Apparently, Fed speak over the past couple weeks has convinced most market participants that the Fed wants to keep equity prices aloft.

Next, markets seem to have come to grips with the problems posed by Donald Trump. To present, markets seemed to believe that the U.S. President was more bark than bite. Markets nonetheless gave Trump the benefit of the doubt concerning his plan to cut taxes, deregulate industries, and accord other advantages to businesses and stockholders. Many believed that the “adults in the room” would keep Trump’s “eccentricisms” in check, making sure that the administration would not veer far from orthodoxies. This reasoning was more or less justified during the first year of Trump’s administration, when economic growth and stronger-than-expected corporate profits generated excellent stock performance.

However the backdrop radically changed in 2018, and especially in the last quarter of the year. Despite earnings growth in excess of 20%, thanks to the corporate tax cut, the U.S. stock market stagnated for most of the year before the end-of-year plunge. If a part of the elevated volatility reflects the Chinese economic slowdown, as well as problems in Italy, the U.K. and several Emerging countries, the majority of recent turbulence can be attributed to Trump himself. Slashing taxes at the height of an economic expansion (so un-Keynesian) served to increase interest rates in an economy already at full employment. Since February, markets have been preoccupied by inflation exceeding central bank targets. Then the joust with China over trade and other important trade partners further raised concerns about the sustainability of economic growth.

Concerns of stagflation are also being raised due to other of Trump’s policies. Limiting foreign direct investment and immigration restrictions are a couple of policies that most economists view as harmful in the long-run. With an aging U.S. population, reducing labour market growth will not aid the U.S. economy. Moreover, the Trump administration has yet to propose an infrastructure plan, highly touted during his campaign, to stimulate the productivity or accelerate the transition to a green economy.

Conclusion

In sum, these past years have seen unprecedented happenings in the world of finance. Monetary policy stimulus from the Fed (in addition to other central banks) that was not anticipated by anyone (and was arguably unneeded), the election of unconventional U.S. president determined to wreak havoc in all he does, the resolution to a debt crisis that has nearly doubled the outstanding debt in the U.S. economy, and fiscal stimulus measures — normally reserved for the depths of a recession — enacted near an economic expansion peak. These are indeed interesting times. And unfortunately for investors, times risk to get even more interesting….


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