Events are playing out as one would expect if one subscribes to our view that reduced central bank liquidity coupled with increased deficit spending and Treasury issuance is straining economies and markets in a big way. The impact is broadly negative for credit risk as opposed to increasing inflation concerns. Because of that, it pushes the globe towards the deflation side of the equation. The landscape is simply not as “growthy” as we are told.
Things are breaking in markets, but don’t cry for Argentina. It just got $50 billion from taxpayers through the IMF as its currency and bonds crashed. Brazil and Turkey are in trouble too. We expect more bailouts in other places. All the usual suspects act as if no one could have seen this drama coming. We suggest otherwise.
The Fed raised rates again last week, so it is trying to stay on course in the face of the multiple headwinds, particularly in the emerging markets and generally softer global economies. It is also still shrinking its balance sheet, so the overall amount of tightening is much more dramatic, particularly when rates are rising from such a low base.
The ECB also just announced it will end QE in December, though economic data in Europe has rolled over again. Japan is mildly tapering QE in a back-door manner. The Treasury curve remains flat as if to say central bank buying is not what is keeping the bid in the long end. Growth just ain’t that great, Mr. Powell, Mr. Kuroda, and Mr. Draghi.
Reduced liquidity is forcing a significant re-pricing of numerous sectors and asset classes. Because there is no longer nearly as much central bank largesse being thrown into the system, investors are forced to pick and choose between winners and losers. This creates the growth versus value dynamic that has been so pronounced in recent quarters as participants chase a shrinking group of perceived winners. For instance, some consumer staples and utility stocks are down 20-30% as those are sold to buy things like Amazon and Facebook.
Overall positioning in many markets still seems to pay no heed to the reality that the monetary tide is ebbing although major “accidents” are happening across the planet. What is also taking place is a refusal of U.S. equity investors to head close to shore. In fact, just like past cycles, a strange desire to maintain exposures becomes most pronounced as holes in the bullish narrative begin to appear. Those late to the party want to catch up.
A rolling bear market is taking place in the S&P 500. Every sector in that index has now been down roughly 10-20% at some point in 2018. Market breadth remains challenged as fewer stocks are remaining robust. Many of the stocks that are most beaten-up are the very dividend payers the pundits portrayed as no-lose propositions during QE. Many are down 20-30%. A ratio of market moves on down days versus up days has it historically high levels after last year’s extreme complacency.
Major stresses are appearing regularly. Deutsche Bank is once again enduring intense difficulties. Italian government bonds and stocks came under enormous pressure as populist, Euro-skeptic leadership takes control there. Contrary to the narrative, Italy has been left out of the supposedly strong economic upturn, so outsiders were put in power by disgruntled younger voters. Spain and Germany are also facing less stable political situations.
It seemed everyone had piled into emerging markets. Now those are cratering. Currencies, bonds, and stocks in places like Argentina, Brazil and Turkey have been in turmoil for months because their dollar borrowings are proving painful as the greenback rises in response to the dollar shortage we often discuss. China is showing corporate credit strains and slower growth.
As if these issues were not enough, Trump’s trade policies are a big wild card that should not be ignored by investors. Tariff tweets create uncertainty and worries about higher prices. Though we welcome it, leveling the trade playing field may not be stock friendly.
Based on what we see, it looks like many cracks are being exposed in the narrative that somehow it does not matter that an unprecedented central bank experiment is being reversed by Quantitative Tightening. The rising dollar and interest rates are proving quite troublesome for economies and markets. The Fed will likely be pushed into an easier stance, but maybe not before the damage is more obvious.
We love hearing pundits place central bank policy error at the top of their current worries list. They think Quantitative Tightening, higher rates, and less QE may push markets over the edge. We beg to differ that trying to return to normal is the blunder. The mistake was pursuing ridiculously easy and irresponsible strategies for ten years to the point that current markets and economies are unrecognizable to anyone with a knowledge of history.
The current paradigm is like a doctor, after having put patients on ever higher doses of steroids for years, deciding to no longer write the prescriptions. The weakest patients, like Brazil, Turkey, and Argentina or Deutsche Bank and Italy, are the simply the first to show that the patients’ “recoveries” were a mirage. The central bankers worked no miracles!
The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.