In July, Mad Magazine announced it would cease publication after 67 years. While the magazine might be ending, the image of its iconic mascot, Alfred E. Neuman, will live on for years to come. In many ways, the character with his gap-tooth, carefree smile as the world around him is collapsing epitomizes current market reactions to recent negative headlines. Whether investors should be smiling, let alone carefree, is very much in question.
This past quarter saw investors face an unusual degree of potential risks. The China-U.S. trade deal remained marred by brinksmanship. United Kingdom Prime Minister Boris Johnson and the Parliament tussled to find a suitable Brexit plan. Proxy wars in the Middle East threaten to disrupt global energy supply lines. Protests in Hong Kong grew increasingly violent. In Washington, Democrats opened an impeachment inquiry of President Trump. All of this geopolitical risk added to the volatility of markets but was unable to disrupt the trends in place for most of the year. Markets are known to climb a wall of worry, and the wall of liquidity provided by central banks facilitated the unusual case of significant gains for stocks, bonds and gold, all rising together.
Moreover, the broader global economic context darkened as the underlying path for global growth has slowed appreciably. Global growth for 2019 is projected to be 3%, the weakest since the financial crisis. A modest rebound of 3.4% in 2020 predicted by the IMF is tentative at best, dependent on a continuation of easier financial conditions. At the same time, the IMF also warns, “easy financial conditions are encouraging financial risk-taking and fueling a buildup of vulnerabilities in some sectors and countries.”[i] This is particularly relevant to the U.S., which is attracting investors into dollar assets through some of the highest relative interest rates in the developed world. It is also pertinent to China, where economic activity is expected to grow at a slower than 6% rate. Slowing growth there will put pressure on its more heavily indebted institutions and individuals.
Yet, despite these dark clouds, other data strike a more positive note. Despite global manufacturing appearing to fall into recession, services appear relatively healthy. In this cycle, employment in the U.S. has been remarkably resilient. Strong labor markets and improving wages have contributed to the notion that consumption will remain strong enough to avoid a domestic recession. Looser monetary policy with the appropriate lag gives credence to this notion. Chairman Powell may have been prescient in envisioning the current slowdown as a mid-cycle slowdown. There are early signs in the cyclical and financial sectors of the US stock market that a modest improvement is occurring; meanwhile, German and Chinese stocks appear generally poised to break higher. At the same time, interest rates across the globe are partially retracing the dramatic decline that occurred earlier this year. Whether these movements prove to be a temporary adjustment or a cyclical turn remains to be seen. The evidence given current trade tensions seems to favor the adjustment hypothesis.
However, momentum in the era of easy money tends to support the cyclical case. Valuations of financial assets are elevated but seemingly can remain so. It is no coincidence that risk assets started to outperform in line with the Fed’s decision to begin to expand their balance sheet. The unwind of quantitative easing was a technical tightening of the monetary system. Recent congestion in the repo market provided the perfect excuse for the Fed to react.
Nevertheless, central banks act as if the global economic system is in a fragile condition and stand ready to interact at the first sign of pain. Unfortunately, they can no longer target Main Street without promoting speculation on Wall Street. The tools of monetary policy are nearing or exceeding their limits at a time when fiscal policy is unavailable. The constraint on fiscal policy is both political and economic. Fiscal deficits are restricting the ability of politicians to respond.
Here in the U.S., slowing economic growth may correlate with the presidential election cycle. Managed capitalism is likely to face a significant challenge from managed socialism. Neither philosophy has proved adept at controlling spending. The debate is largely about how to spend the money and who gets to spend it, rather than whether to spend at all. Regardless, reality will require an aggressive spending policy in the U.S. should it enter a recession. Modern Monetary Theory appears poised to leap from theory to practice in either case.
Interest rates seem mispriced for such an outcome. Rising rates are the only mechanism to control the potential for reckless debt-financed government spending at which both parties have proved proficient. Policymakers will face headwinds in regard to rising rates. The buildup of debt promoted since the financial crisis portends serious, deflationary consequences. As a result, fiscal policies will be only marginally successful.
Globally, the ability of policymakers to trade their way out of excessive leverage is approaching a critical juncture. The developed world faces deflation from demographics and advances in technology. Declining income threatens the ability to service the public debt. Emerging market countries can gain from this shift. Favorable demographics, rising incomes and productivity gains make the emerging market countries better positioned to narrow the gap in living standards. In the best case, the developed world can maintain their standard of living as the emerging world catches up. The comparative advantage of trade increases the odds of the best case. Attempts to undermine global trade threaten this win-win proposition.
For now, the turmoil of global events has left the markets largely unscathed. Time will tell if investors’ smiles are warranted or merely wishful.
[i] International Monetary Fund, Global Financial Stability Report (October 2019). Available online at https://www.imf.org/en/Publications/GFSR/Issues/2019/10/01/global-financial-stability-report-october-2019.
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