Today’s Market Tremors Are Self-Induced

Michael J. Kelly, CFA
Global Head of Multi-Asset
New York

12 August 2019

Like converging tectonic plates, two forces currently are at work shaping the global economy. One is a healthy consumer, confident of employment conditions and propelling growth. The other is manufacturing, where trade skirmishes have frozen corporate decision-making, propelling manufacturing weakness of tradable goods.

We see two potential outcomes ahead: Either manufacturing will converge up toward the consumer, or the consumer will converge down toward manufacturing, threatening recession.

Central banks everywhere are easing in an attempt to skew the odds toward the “converge up” scenario. But their toolboxes are not equipped to fix the uncertainty harming manufacturing. Businesses can adjust to any environment once it’s somewhat predictable. So trade uncertainty must plateau soon.

Higher currency volatility has now joined higher stock and bond volatility

Currencies also recently stirred, and a new development suggests there’s more shakeout to come. Hong Kong Chief Executive Carrie Lam’s decision to quietly change a one-off extradition treaty between Hong Kong and Taiwan into a perpetual three-way law among mainland China, Taiwan, and Hong Kong was ill-fated, initiating the latest unrest in Hong Kong. While the Hong Kong dollar is pegged to the US dollar, this event’s resulting uncertainty must be played out elsewhere in markets.

China had been playing a stabilizing force in currency markets, leaning against downward market forces. This changed briefly after President Trump threated to weaken the US dollar, and the European Central Bank threatened a new round of quantitative easing, which would surely weaken the euro. As a result, China let the yuan go briefly a bit beyond 7.0 to the dollar to send a message that it might use currency depreciation as a trade war defense.

Arresting the development of the business cycle

Today’s angst is exacerbated by those who believe the cycle is close to an end and go from jogging toward defensive assets to sprinting on any signs of trouble. We have pushed back against such recession views since 2016. Three years later, this long-feared recession has still not arrived.

Yet markets are now in the later stages of the middle of the business cycle. This is not so much due to the passage of time – it’s more the result of the chaotic manner in which trade policy has unfolded. Poor communication and implementation of the US’s desired trade reset have spiked uncertainty, pre-empting the business investment upon which a healthy extension of this cycle depends.

We nonetheless still see the earliest likelihood of recession as 2021, with the ability for the cycle to extend several more years if self-induced uncertainty plateaus. Yet it could also end sooner if trade uncertainty amplifies, in which case President Trump will be out of office.

A new mantra?

Today’s economic weakness emanates not only from trade, but also from 2018’s Fed tightening and China’s deleveraging. Both of these have reversed from headwinds to tailwinds, which is why powerful forces are lining up against the fault line. No wonder volatility has spiked.

Defensive assets have thrived in this highly uncertain environment, yet will lose money from here unless the worst case materializes. Offensive assets are now priced like a tightly coiled spring, and should make money unless the worst case materializes.

The “don’t fight the Fed” mantra now seems a bit outdated. Today, it’s more like “don’t fight every central bank in the world” – and the need for President Trump’s survival instincts to kick in.


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