Sunday, 20 January 2019

I'm a believer

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  • Peters 475px June 2014
  • Reuters

Who are we to believe? Do we believe President Donald Trump and his up-beat State of the Union address or do we believe the stock market? 

The S&P saw the biggest fall in since August, 1.09% to end the day at 2,822.43, and the VIX index shot up to close at 14.79, having touched on 15.42 in intraday trading. 

Do we run for the hills because the US 10-year note is trading at a yield north of 2.70%? Or do we wait for FOMC to finish its two-day meeting today and the release of the statement tonight before hanging ourselves? 

Before even looking at the State of the Union address it would be wise to bear in mind that January set all manner of records for US stock index performance and that even after taking a 362.59 point or 1.37% hit on Tuesday, the Dow is still sporting a 5.49% year-to-date gain which, if annualised, would offer a 60%+ return before dividends. 

The racing certainty that this is not going to happen should therefore have us accept any decent reversal as neither a surprise nor as the end of the world as we know it. Just two days ago that year-to-date rise was 7.49%, an even more ridiculous number to annualise and probably a capital gains return that most investors would be secretly happy to accept at the end of the year. So what’s wrong with taking a few chips off the table and locking in some of the month’s gains? A reason to panic?


Bank statement

On the other side of the equation we enjoyed, if enjoyed is the right word, the president’s set piece performance in Congress. This was the Donald’s first State of the Union address and what a show it was! To be honest, he really does have plenty to crow about: the economy appears to be in rude health with solid growth, and wage growth, albeit still stuttering, has resumed and the stats show record low unemployment. Taken at face value all is fine in the garden and Trump, ever the showman, didn’t miss a trick on that front. He appeared significantly less combative than many had expected and although he took every bit of credit for the rise in markets and the generally buoyant mood in the economy, he refrained from beating up on the Democrat opposition and neatly circumnavigated most of the controversial issues that have had Congress in near-deadlock since he assumed the presidency. 

He appealed for unity in helping to appropriate US$1.5trn for urgently needed and long overdue infrastructure spending. In context, aggregate federal, state and local authority tax take amounts to approximately US$6.5trn per year. Against that stands close to US$7trn of spending so the gross public sector deficit is already around US$500bn per year. Now he intends for the three levels of the public sector to somehow find another US$1.5trn for infrastructure. America is between a rock and a hard place. It cannot afford the infrastructure upgrades it so badly needs while, as Trump has quite correctly taken on board, it can do without them even less. 


Musical chairs

The speech was full of “ra-ra-ra”, which will have done nothing to unsettle believers just as it will have done nothing to assuage sceptics. But what about markets? The incoming chairman of the Fed, Jerome Powell, hails from the same dovish tradition as did Janet Yellen so there is little need to fear too many curve balls on the monetary policy front. He is also a former banker so one might be able to expect him not to regard the banking sector as the enemy. A tightening of headline monetary policy could find itself offset by a relaxation on the reserve requirement front, which has, as most bankers would agree, gone more than just a bit too far in the aftermath of the financial crisis.

Although it is the Chinese shadow banking sector that makes all the headlines, one should not underestimate the amount of non-bank lending in the US. Much of the growth in that sector is the result of more stringent controls imposed on the banks. The fact is that if credit is needed, credit will be provided and the harder it is made for the banks to lend, the more of it will end up in the shadows and away from central bank and regulatory control. Instinctively Yellen, an academic, wanted to see the banks do penance. Powell, my guess, will see bringing back consumer lending into the light as one of his principal tasks. But that’s for the future. 

Trump’s view, right or wrong, is that the US cannot negotiate from a position of weakness and that America First strengthens its starting position. Anybody who sails will know what it feels like if the boat comes to a full halt in the middle of a tack and that that is what happens to inexperienced skippers and crews. In that vein American diplomacy has stalled in mid tack but the Donald Trump on display today looks like a man who has learnt a few lessons over the past year. A few; no more than that but even the longest journey begins with a single step. The real test will come not under Trump but under his successors when we learn whether the boat has been turned back into the wind or whether it will follow a similar course.


Tight fit

So are bonds back in the driving seat and will yields continue to rise, knocking the stuffing out of equity markets? My own core scenario remains that the Fed, along with the rest of us, fears nothing more than an implosion of asset prices. The logical conclusion is that will sound more hawkish than it intends to be, that it will be über-cautious in tightening policy and that whatever tightening there is will be offset by supporting a loosening of regulatory constraints on the credit environment. My core scenario that it will let the curve steepen by letting the long end drift higher without pushing front-end rates higher remains unchanged. This is now not only 3D chess, it is 3D chess with more than just black and white pieces. 

Even without the risk of imminent further tightening, European bonds ain’t pretty either. The 10-year Bund, the DBR 0.5% August 15 2027, closed the year at 100.72 and a yield of 0.423%. That bond, now replaced as benchmark by the DBR 0.5% 2/2028, is trading at 98.97 and a yield of 0.613% at the time of writing. Bunds, therefore, are already in a solid negative total return for the year and they don’t look like they’re going to be getting any better unless a black swan chooses to land somewhere on the sea of debt. We hate equity levels and we hate bond yields even more. Maybe time to cash out and take a decent holiday although “sell in February and go away” doesn’t really rhyme too well.

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