Financial Markets and the Adverse Effects of Stability

The most important development this week was the Trump Administration announcing on Monday that it will impose tariffs on $200bn of imports from China.  Tariffs will initially take effect at 10% on those products but are scheduled to increase to 25% in January 2019 if there’s no resolution.  Stocks dipped a bit on Monday, but they have since recovered with both the S&P 500 and Dow Jones Industrial Average closing at their all-time highs on Friday.  This week exemplifies what seems to be a developing trend in which investors have become desensitized to these negative headlines.  Whether it be emerging market weakness (i.e. Argentina, Turkey, Brazil, Russia) or trade war escalation—all investors who have decreased exposure to US risk assets on these headlines over the past few months have drastically underperformed and have thus seem to have been almost conditioned to mostly ignore these headlines.  Many managers are now chasing performance and need to stay invested, and this has lead to a “buy the dip” mentality.  “Bears sound smart but bulls make money” is a phrase I’ve heard a lot in the past few months.

Overall, the effects of these tariff measures on both real GDP growth and inflation are expected to be pretty moderate, but there is still risk of further escalation from here.  The White House statement ( indicates that “if China takes retaliatory action” against farmers or other industries, the US “will immediately pursue phase three, which is tariffs on approximately $267 billion of additional imports.”  However, it does look like China is retaliating—on Tuesday, they put tariffs on $60bn of US exports.  It seems like escalation to some sort of “phase three” tariffs that cover all Chinese imports is slowly becoming more and more likely.  It’s probably not the official market view yet, but the Trump Administration has set up this conflict in a way that makes it nearly impossible for this issue to be resolved over the next few months.  The demands that are being made of China are simply too existential for the Chinese to capitulate on anytime soon.  It’s very difficult to tell where the market expects these sanctions to go and what’s already “priced in.”  Some economic analysis suggests that tariffs on all Chinese goods would only reduce US real GDP growth by ~0.5%, but this is imprecise work because it only takes into account income effects.  There are a bunch of other indirect costs, such as confidence and financial conditions, that can’t be easily modeled.  In addition to these risks stemming from trade war escalation, there is also contagion risk stemming from several country-specific situations.

Turkey is currently in the midst of a currency crisis with the Turkish Lira down ~40% YTD. However, this could morph into a banking crisis or a private or sovereign default.  Further FX weakness could pave the way for debt repayment difficulties due to dampened future income in FX terms, which would in turn lead to a rise in non-performing loans in the banking system.  Rising non-performing loans in the banking system could in turn negatively influence their capital adequacy ratio and profitability.  This presents significant counterparty/contagion risk—especially in Europe, which is the most exposed to the region in terms of direct exposure to Turkish banks and corporates.  Argentina is also in the midst of a currency crisis.  The government has gone a long way in reducing the twin deficit problem (from last year to next year, the current account deficit will go from -5% to -1% and the budget deficit will go from -4.2% to flat).  The government has also been successful with monetary tightening and could still tighten further.  Argentina will also be isolated from market volatility in terms of financing through 2019, thanks to the IMF program.  However, the problem remains that for Argentinian Peso inflation to converge to a single-digit number by 2021 (the current goal of the IMF), they will have to tackle the issue of indexation of prices and salary backward-looking weight increases.  This will require congressional support, and it will be very unpopular.  Thus, it is very likely that Argentina will have to continue living with a double-digit inflation rate for the foreseeable future.  In the past, the FX market has been a precursor to runs on deposits in the banking system.  It could also engender the sustainability of the adjustment program, and it could erode popular support for the government and cause political turmoil.  The political cycle will further elevate uncertainty: elections 12 months away, and the odds of Macri getting reelected are continuing to drop.

There is no doubt that the Fed is tracking these global developments very carefully and factoring it into their outlook for the US economy.  However, the Fed’s mandate is domestic and these developments are not yet at the stage where they’re going to affect policy (even to the point of changing their language in an upcoming statement).  With growth strong and inflation hitting the Fed’s mandate, the Fed is probably going to raise two more times this year and at least three times next year.  Life will probably get more difficult for emerging markets from here.  Even as it gets more serious, it’s still difficult to imagine the Fed altering its policy.  The Fed’s job is to get things right in the US, and the rest of the world will benefit if they achieve that.  If they pause due to pain in EM and allow for inflation to take off more than desired, there will be a lot more pain later down the road.  The following chart depicts the divergence in EM stocks vs US stocks:

So why exactly are US stocks at all-time highs?  Well these issues haven’t materialized in U.S. data yet.  The U.S. economy is expected to grow at 5-6% in nominal terms in both 2018 and 2019.  U.S. company earnings have been very strong and S&P 500 earnings are projected to grow at ~15% and ~10% in 2018 and 2019, respectively.  Inflation remains muted with 2018 and 2019 CPI forecasts at 2.5% and 2.3%, respectively.  The Fed has also been hiking at a very gradual and non-threatening pace, as depicted in the graph below.

Lastly—and perhaps most importantly—stocks aren’t too expensive when compared to bonds.  The S&P 500 trades at ~18x forward earnings, or a 5.5% earnings yield.  When you take into account the fact that these earnings are growing nicely over the course of this year and next, it makes for a relatively attractive investment as opposed to a 10-Year US Treasury that only yields 3.06%.  Although it definitely seems like rates are rising, they appear to be somewhat capped by the German 10Y.  A good rule of thumb is that the interest rate on the US 10-Year Treasury should roughly equal the nominal GDP growth rate.  If this rule is true, why aren’t 10Y yields at 5% or 6%?  The answer is that they would be if the US economy was completely isolated from the rest of the world.  However, it isn’t.  In an interconnected global economy money can flow from other countries to the US.  Thus, with German 10Y Bunds yielding ~47bps and Japan Government 10 Year bonds at ~0%, a 3% US 10Y yield looks pretty attractive.  As you can see in the graph below, US 10Y yields have almost directly followed the average of nominal GDP growth and the yield on the German 10Y.  With some quick math, we can average the current 5.4% nominal growth as of 2Q18 with the 47bps German 10Y yield to get 2.94%… not to far off from the current 3.06% yield.

Thus, until the aforementioned economic environment changes, US stocks can still go higher.  However, when the data does change things could end up being pretty bad.  In August, the current bull market in US stocks became the longest one in history.  Volatility has been relatively subdued and massive quantitative easing programs have created a tremendously stable bull market run.  I think this long period of stability could result in a very harsh movement in asset prices when the economic environment changes.

It may be somewhat counterintuitive, but stability is not always good for the economy.  Firms, countries and other economic systems become very weak during long periods of steady prosperity devoid of setbacks.  This is because hidden vulnerabilities accumulate silently under the surface (remember the 2008 Financial Crisis?).  To borrow from Nassim Nicholas Taleb in his book Antifragile, variations act as purges.  Small forest fires periodically cleanse the system of the most flammable material—hindering the opportunity to accumulate.  Systematically preventing forest fires from taking place “to be safe” makes the big ones much worse.

In markets, fixing prices, or, equivalently, eliminating speculators (and the moderate volatility that they bring) provides an illusion of stability, with periods of calm punctuated with large jumps.  Because players are unused to volatility, the slightest price variation will then be attributed to insider information, or to changes in the state of the system, and will cause panics—January of 2018 is a great example.  When things don’t vary, a very slight move makes people believe that the world is ending.  Injecting some confusion stabilizes the system.

Many old trading veterans use a simple heuristic: when a market reaches a “new low” (i.e. drops to a level not seen in a long time), there is “a lot of blood” to come, with people rushing to the exit.  Some people unused to losing money will be experiencing a large loss and will incur distress.  Tellingly, they call it a “cleanup,” getting the “weak hands” out of the way.  When many such weak hands rush to the door, they collectively cause crashes.  A volatile market doesn’t let people go such a long time without a “cleanup” of risks, thereby preventing such market collapses.

In sum, the current desensitization to headlines and a “buy the dip” mentality could continue to send stocks to new heights, but when things change—as they always do—things could get pretty ugly.

Top 10 Reads of the Week

  1. Ray Dalio: A Path to War? 
  2. Siegel vs. Shiller: Is the Stock Market Overvalued?
  3. Flirting with Models: The Misleading Lessons of History
  4. WSJ: Wall Street’s Marijuana Madness: ‘It’s like the Internet in 1997’
  5. WSJ: China Retaliates with Tariffs on $60 Billion of U.S. Goods
  6. Financial Times: Iran Accuses US of ‘Starting a War’ in Fight Over Sanctions
  7. Financial Times: Fed Funds Rate Set to Rise Past Inflation for First Time Since 2008
  8. Financial Times: Why Investors Should Worry About Rising Wages
  9. The Economist: Jair Bolsonaro, Latin America’s Latest Menace
  10. The Economist: Why Russia and China’s Joint Military Exercises Should Worry the West

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