Daily Comment (November 20, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT]

(NB: The Daily Comment will go on hiatus beginning Wednesday, November 21st, returning on Monday, November 26th.  From all of us at Confluence Investment Management, have a Happy Thanksgiving!)

Another down day for equities—stocks continue their slide.  News flow was surprisingly light overnight.  Here is what we are watching:

Equity markets:  Stock markets around the world continue to struggle.  Although there are some earnings issues, for the most part, weakness is coming from multiple contraction, suggesting investor sentiment is waning.  The current weakness is specific to two factors—fears based on Fed policy and Trump administration trade policy.  The first problem is not unusual.  The FOMC has been steadily raising rates and we are now seeing the policy rate reach a level that, by itself, isn’t necessarily restrictive but could become so in short order if comments from Fed officials are accurate on the future path of tightening.   A related concern is that policymakers appear to be abandoning, or at least questioning, the Phillip’s Curve construct without offering another framework for setting policy.   One trend that does appear to be in place, however, is that investors, for the first time in years, appear to be considering cash and near cash instruments as an asset class.  In simpler terms, “cash is no longer trash.”

The trade issue is much more confounding.  Since the end of WWII, U.S. trade policy has been set on open and free trade.  In practice, this meant the U.S. acted as importer of last resort and ran persistent trade deficits to provide the world with the dollar, the global reserve currency.  Although this policy was key to winning the Cold War and boosting globalization, it has detrimental effects on equality in the U.S.  It has become clear that political support for free trade is waning; in the last presidential campaign, for example, both candidates promised to jettison TTP, a trade arrangement with the Pacific Rim.  Restricting trade will tend to undermine efficiency and eventually lead to higher inflation.  However, in the short run, the more likely impact will be a reduction in margins.

What is generally unappreciated about the administration’s trade policy is that it appears to be a reversal of over seven decades of U.S. policy.  In fact, we would argue that the last time the U.S. took broad actions to restrict imports was during the 1920s.  Thus, no economist today has a working economic model that incorporates deglobalization.  This creates uncertainty which the equity markets are struggling to discount.

Currently, there is hope of some sort of trade truce at the G-20.  The continued weakness in equities may be enough to lead the president to “call off the dogs” for a period of time.  However, our view is that the president’s core belief is anti-trade, at least in the form the U.S. has pursued since WWII.[1]  We believe the person in the administration that most closely mirrors the president’s trade policy is Robert Lighthizer.  His view essentially favors the deglobalization of supply chains—in other words, he wants to bring production back to the U.S.[2]   The policy is also treating China as a strategic competitor,[3] in a fashion not like we treated the Soviet Union, but more like how Britain viewed Germany before WWI.  Thus, any easing of trade tensions that come from the G-20 probably won’t last.  Instead, the goal will be to stabilize markets.  So, we would not be surprised to see the president attempt to temporarily ease market concerns but one should be cautious about expecting a retreat from trade policy.

After the holiday, we are launching a three-part series on the evolving superpower policy of the U.S.; it is titled “The Malevolent Hegemon.”  Our thesis is that the narrative that the U.S. is abandoning its hegemonic role is probably not true.  Instead, the U.S. is changing how it exercises that role and doing it in a manner that is much less friendly to the rest of the world, thus shifting from the previous model we dub “The Benevolent Hegemon” to the Malevolent Hegemon.  On trade, a key component is to shift trade negotiations from multilateral, which tends to restrict American power in trade, to bilateral, which enhances it.  In the end, it isn’t clear to us if it will work.  But, we don’t think the evolution of U.S. policy should be seen as isolationist.

Overall, the economy is still doing well and earnings, while probably peaking in terms of growth, will likely remain elevated.  And, seasonally, we are in what is usually a bullish environment.  Thus, we would not be surprised to see a recovery in the near term.  But, a lift will likely need a catalyst, either in the form of a trade truce or some indication from the Fed that a pause in tightening policy is being considered.

Rising tensions in the royal family:  The Khashoggi affair adds to previous evidence that the crown prince, Mohammad bin Salman, is mercurial and his policies could contribute to regional instability.  As we argued in the last WGR, we would expect other potential claimants to the throne (the grandsons of Ibn Saud) to try and unseat MbS.[4]  Reuters is reporting that the royal family is considering putting off the decision of which grandson will become king by putting the last “king-eligible” son of Ibn Saud, Prince Ahmed bin Abdulaziz, into the king’s role after the death of King Salman.  Our fear is that the transition will not be smooth; MbS has become quite powerful and would likely move quickly after his father’s death to secure power.   We believe financial and commodity markets are underestimating the potential disruption to regional stability and the oil markets from succession.

EU sours on Iran:  Although the EU clearly didn’t care for the Trump administration’s decision to exit the Iran nuclear deal, support for helping Iran break sanctions has taken a blow after Tehran was implicated in plots to assassinate Iranian dissidents in Denmark and France.[5]  If Europe turns on Iran over these issues, it would be a diplomatic “own goal” for the mullahs.  It would also be bullish for crude oil.

Brexit update:  Not a whole lot more to report.  The Tory rebels still don’t have enough letters to bring a leadership vote.  There is widespread discontent with the deal May negotiated with the EU but no one has come up with a better offer.  The three outcomes—the current deal, a hard Brexit with no deal or a new referendum—all remain on the table.  Given that neither the current deal nor a hard Brexit appears attractive, we would not be surprised to see a new referendum.  It is not out of the question that the U.K. decides that being in the EU isn’t all that bad (especially if one isn’t in the Eurozone) and if the U.K. can negotiate some degree of border control on immigration (which, by the way, is happening all over Europe), we may see a reversal of Brexit.

The Swiss consider nationalism:  This Sunday, Switzerland is holding a referendum on “self-determination” which would make the Swiss constitution supreme over any international treaties the country joins.  Thus, if the Swiss pass a referendum at a future date that conflicted with an international treaty, the agreement would have to be either renegotiated or cancelled.[6]   If this measure passes, it will make it very difficult for any future Swiss government to negotiate treaties because the other parties will never know if the pact will be rejected at some point by a future referendum.  We view this vote as another example of rising opposition to globalization.

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[1] https://www.wsj.com/articles/trump-forged-his-ideas-on-trade-in-the-1980sand-never-deviated-1542304508

[2] https://www.ft.com/content/0cf1948c-ebba-11e8-89c8-d36339d835c0 and https://www.wsj.com/articles/a-silicon-valley-tech-leader-walks-a-high-wire-between-the-u-s-and-china-1542650707?tesla=y

[3] https://www.ft.com/content/6ffc7756-ec58-11e8-89c8-d36339d835c0?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56 and https://www.washingtonpost.com/technology/2018/11/19/trump-administration-proposal-could-target-exports-tech-behind-siri-self-driving-cars-supercomputers/?utm_term=.efba287538c0

[4] https://www.reuters.com/article/us-saudi-khashoggi-royals-exclusive/exclusive-after-khashoggi-murder-some-saudi-royals-turn-against-kings-favorite-son-idUSKCN1NO2KP

[5] https://www.reuters.com/article/us-iran-nuclear-eu/eu-open-to-iran-sanctions-after-foiled-france-denmark-plots-diplomats-idUSKCN1NO1OQ?il=0

[6] https://www.ft.com/content/67c3950a-e826-11e8-8a85-04b8afea6ea3