It ought not to come as a surprise to regular readers that the first Quarter of 2018 ended by defying its bullish start, perched atop a sea of reports from wealth managers bristling with positivity about growing GDP for all G20 economies, global regions acting in synch for the first time since the GFC and improving business earnings all around. It hasn’t happened.
The year sprinted off to the type of start that bulls predicted in their Xmas holiday forecasts grounded by rising earnings, accelerating economic expansion and an expectation that the US Federal Reserve Bank would gently apply interest rate rises, unfazed by fears of rising inflation. You’ll recall from this blog https://hobbsfinancial.ie/january-2018-irrational-exuberance-phase-arrived/ at the outset of January, that I’d remained sceptical, a viewpoint teased out in The Pivot.
For most of January it was all was going according to the bullish script, with the S&P 500 (which tracks the fortunes of the USA’s top 500 companies) leaping +8% in just three weeks. Then came the spasm in week one Feb.
By the time the shutters came down at the end of March, the S&P had retreated to -2.2% for the first quarter, a fall of over 10% from its peak, the Eurostoxx 50 was down -4.5% year-to-date and, in an uncommon correlation with equity markets, the bellwether US 10-year Bonds had declined -2.7% on fears of Fed rate rises, meanwhile Oil rose by over 5%.
Underneath the headline data, lies another, interlinked story. The cost of getting US long term debt issued, relative to other first world countries, has been rising on concerns about US creditworthiness and its thinning as holder of the world reserve currency, now down to 62.7% of overall global foreign reserves, reducing the demand to recycle surplus into US treasuries.
The US stock market, despite rising earnings, has seen price falls that has lowered multiples on the S&P 500 from 18.5 times to 16 times despite tax cuts. Generally rising interest rates ought to strengthen the US Dollar but it has been weakening and the US Treasury Department is now paying more to get debt away.
Join the dots and the market is losing faith in the ‘Trump Trade’ as fast as the US President has lost key personnel, in short brand USA is tarnishing leading some to suggest that its privilege as issuer of the world reserve currency is in its sunset. If so IMF plans reported by writer Jim Ricard to replace the US dollar with its own currency unit, Special Drawing Rights (SDR) at the institutional level, to avoid a liquidity problem caused by a loss of confidence in the US dollar, may hold water.
Whatever the case, Trump’s volatility exacerbated on Monday April 9th when the offices of his personal lawyer was raided by the FBI and his America First agenda looks like it is playing into the hands of those who would gain most by US isolationism, a peel back of Pax America and a US dollar decline, just at a time when the US hopes to raise an additional trillion dollars to fund Trump’s tax cuts pushing overall US debt to over $21 trillion.
China at $1.2 trillion is the single largest holder of US debt, so starting a trade war with China could hasten further Dollar decline.
Trade Tensions Escalate in April
Gold has held its value and bonds are strengthening as markets absorbed Trump’s intention to fulfil his campaign promise to pick a trade fight with China. The No.1 and No.2 global economies are promising to hit $100bn in trade between each other with heavy tariffs.
The US, whose trade deficit with the rest of the world grew by one 1/8th from $505bn in 2016 to $568bn last year, is particularly aggrieved with China which accounts for $337bn of the deficit, that’s 60% of the US global trade deficit, the remainder spread about; $69bn with Mexico, $68bn with Germany, $56bn with Japan to name the nearest three. This can be compared to US GDP at over $20 trillion.
What rattles markets is uncertainty, will Trump pull the trigger, he certainly seems intent on doing so, briefing a radio interview April 6th that markets should prepare for pain. Maybe he figures that he has a lot of political capital in the bank; coinciding with Trump’s election in 2016, global market capitalisation has leapt from $65 trillion to $80 trillion, with the S&P 500 adding over 20% to its collective value. Trump seems set on losing some of this, temporarily, as he sees it, while he probes aggressively for a deal with China whom he figures cannot gamble with internal instability if Chinese exports cool off in a trade war. Chinese President Xi Jinping striking a balanced note about internal Chinese market deregulation temporarily calmed tensions on April 9th but the pace is being set by Trump.
Proving that there is no winner in the tit for tat business of trade wars, Trump is targeting Chinese solar panels, washing machines, steel and aluminium, slapping tariffs of 25% on Chinese goods, while China has responded with threats of similar tariffs to US soybeans, aircraft and chemicals, hitting in states with slender Trump majorities just when the US President faces into mid-term elections in November which, even before the potential of a trade war, may result in Republicans losing their majority in Congress.
There is much at stake and lurking in the undergrowth is more chatter about the US sustainable advantage as the issuer of the world reserve currency.
What About Asset Values – Can the Centre Hold?
We appear to be at a pivot point, bonds which generally are inversely correlated to equities much like the brake is to the accelerator, moved in step in the first quarter. While this is rare, it is not unprecedented, and was caused principally by the expectation of bonds reaching an inflexion point after three decades of falling bond yields, which had gifted investors in sovereign bonds a long run of strong premiums over cash deposits.
Equities, already priced at high multiples of earnings, are very sensitive to any news that deflates the bullish forecast of earnings expanding and business margins unthreatened by rising labour leverage which is common at this stage in economic cycles characterised by near full employment.
The equation most watched is inflation, where is it heading, how will it plateau, why hasn’t higher inflation yet arrived? Accurate crystal ball gazing requires calling inflation and understanding the speed and slope of rising interest rates which in turn raises the question about how this will play out across highly indebted countries and zombie companies kept alive by ultra-low interest rates.
For all asset classes it is a tricky time. Equities at these prices sit on a trap door, property prices are at or above GFC peaks in many markets, fixed interest bonds are facing, at best, mild declines as rates rise, deposit rates are near zero and parts of the banking market look weak and contagious. Mobile capital has searched and destroyed yields everywhere on modest risk assets and depressed yields on high risk assets to unrewarding levels.
Return Of Money vs Return On Money
How long this can hold without adjustment is a more important question in my opinion than looking for reasons to support the bull view of inflation-free expanding economic growth and corporate earnings
At best even if global growth holds up, it looks like it will continue to be a nervy year characterised by big swings in equity prices, volatile bond prices and mixed signals on inflation, overarched by an impulsive US President imposing an economic agenda driven by domestic US campaign promises.
It is the downside risks that are more deserving of attention, when, as appears the case, the point of reasonable doubt about the bull scenario, has been passed. If, as Trump has threatened, he proceeds with a full-blown trade war with China, global economic growth will be damaged and it will bring collateral impacts that have yet to be understood.
Coming in the heels of Brexit uncertainty and changes to US corporate taxation, the threatened trade war adds to the external shocks that could derail Ireland’s economic recovery and asset prices here at home.
The Pivot addressed the likely structural issues embedded in the global economy, too much debt not supported by sufficient economic growth to sustain it. That is unchanged. Although there is likely to be little reward in the near term from maintaining a cautious stance across asset classes, patience will be rewarded when risk asset prices hit new troughs and fresh opportunities arise to buy in at much better value.
For cautious investors while returns that are mildly negative, flat or barely positive is frustrating, it is still the right time to stay assets riding through the events that have yet to come, made easier by grasping that the traditional safe harbour of cash deposits has been weakened by credit downgrades across previously ‘safe’ banks. It is why in this climate getting a return of money is more important than getting a return on money.
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Eddie Hobbs, April, 2018
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