Markets in the first few months were kind to journalists/analysts and global macro traders alike. Recently, trading themes developed so rapidly they created too much overlapping effect. Since the market woke up and smelled the prospects of 3% 10Y treasury yield in early February, we’ve seen a new Fed chair in action, global trade war fear, increasing clout of hardliners in the White House, intensifying Mueller investigation, escalating geopolitical risk in Syria and Saudi Arabia, weakening tech stocks, record US treasury auction, to name a few. With headlines like these, even the upcoming US-N Korea meeting has been drowned out. The chief economist at CME Group recently called this period a phase transition akin to a pot of boiling water with great turbulence at the top and calm beneath the surface. Multiple price peaks and valleys had been created in a short period of time, representing many opportunities to exploit.
All this is very similar to the 2016 election night, played out in slow motion. Then as now, multiple macro themes emerged, correlations were broken, and the transition was messy. One of the things George Soros is famous for is his ability to switch his opinions on a dime when facts warrant it. There certainly have been many occasions to practice that skill lately. Although the jury is still out (and will be for a while) on the net effect of recent development, there are clear signs of some longer trends taking shape.
The stock market is likely in a late-stage rally. Tax cuts without reforms represent a major multi-year fiscal stimulus that raises inflation. The spending gap will need to be financed by more treasury sale, increasing future debt servicing costs at a time when the Fed is raising rates and unwinding asset purchases. This also comes at a time when China is contemplating dumping US treasury as a short term trade war lever. Granted, the fiscal deterioration is a future event, and now that the rate hikes and Fed unwinding have been baked in the cake, a gradual rise of inflation and yield should not shock anybody. We have heard Secretary Mnuchin express confidence that there are enough buyers of US Treasury around, and since there is a general shortage of safe assets these days he is probably right. By dumping US Treasury China can indeed punish America in a nasty trade war but it will inflict enough damage on itself and its exports that rational leaders in China are not likely to commit to it. However, one cannot rule out a short term scenario where the mere threat of it creates a panic in the market. It is a complex development that requires constant monitoring.
To create predictive models, one needs to start with the man’s worldview and ego. Aligning one’s business with his 1950’s version of American prosperity and world pecking order, his worship of money and business, his need to feed his ego /popularity /instant gratification, his transactional view on relationships, and his underdog mentality can be very beneficial. From his fondness of resources and heavy industries, handling of racial issues, hostility to regulations/environment in favor of businesses, tax cuts for the wealthy, to his “TV-ready” combative approach to everything, his moves can be amusingly predictable.
As the year began, the market has started to experience boundary conditions just as Trump officially removed his shackles. Trade hawks, national security and diplomacy hardliners, are now taking charge. Translation: mercantilism, deregulation, manage in chaos, hog the headlines, hire hawkish advisors, respect the Russians, bully the Asians, trample on everyone else (unless rich), look tough on TV/Twitter, please the crowd, double down on criticism. Throughout the chaos, there is consistency in his response.
Rising Geopolitical Tensions
Politics is starting to move markets. American withdrawal from the world, particularly the Middle East, creates a power vacuum and unstable new alliances that have lasting implications. As leaders learn to manipulate Trump’s ego, emboldened authoritarians will be more willing to take risk, creating unintended consequences. Countries in SE Asia and Eastern Europe prepare to fend for themselves against China and Russia; Japan is accelerating the movement to abandon its pacifist constitution; Russia and Iran step up their power grab in Syria while Turkey and Israel react aggressively; Saudi Arabia forges deeper petro-ties with Russia; authoritarians run sham elections and repress their people with ever more vigor while the American president looks on with admiration.
We have observed recent changing correlations reflecting this, e.g. oil followed supply/demand last year before tracking the stock market in January, then geopolitics took charge since March. Gold was vulnerable to interest rates and US dollar for a long time until recent risk-off sentiment kicked in. One place where this shows up is the widening gold/silver price spread.
Rising Protectionism and Populism
Trade wars are hugely influential on the macro environment. Reduced international cooperation and rising domestic political pressure may affect global growth, currency moves, and political outcome. Cases in point: Mexico election, American pork and soybean exports. The nascent recovery of grains and meats sectors had been squashed prematurely. Although recent trade tariffs and tit-for-tats may not escalate into a full blown international trade war, the current American administration’s mercantilism attitude is on clear display. There are no sacred cows and there are nearly no special relationships or strategic partnerships when it comes to “paying” America. Countries can buy good graces by importing more American goods or simply giving the president a good headline, every so often. The Saudis scored points by buying more American weaponry; the South Koreans were punished on a trade agreement in the middle of a North Korea nuclear crisis talk. NAFTA talks were linked to the Mexican wall while the popularity of the populist Mexican presidential candidate is surging.
Protectionism tends to cause concentrated gain (producers) and large distributed pain (users), which only makes short term political sense. The worst part of it all is not only the haphazard implementation of trade tactics, or that cold economic logic takes a backseat to manufactured rhetoric that fits the America First narrative. True, American capriciousness may foster closer trade ties among European and Asian economies but it risks the disintegration (without replacement) of the World Trade Organization without active American support, with disastrous economic outcome for all.
Volatility Is Your Friend
It is noteworthy that these phenomena do not exert themselves in isolation. In a dynamic, non-linear system, outputs often become inputs; effects on the margin are disproportionately large. Throw in human emotions in these trying times, sudden large moves and sudden correlation changes can be expected to happen more frequently.
History (and future) is path dependent. There is nothing inevitable about the continuation or destruction of the post-WWII world order maintained by American hegemony. What takes place largely depends on the decisions and motivations of those in power. The severity of damage in making the wrong move is largely unknown, but it comes at a time when our fragility is high. An entire generation of investment professionals who had never seen volatility will be severely tested in the coming years. It will not be kind to mediocrity.
April 23, 2018
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