Daily Comment (October 25, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s the fourth day of what has been a tough week.  Yesterday’s equity market sell-off was clearly a shocker.  Although there is other news this morning, including the ECB meeting, we start today with thoughts about equities:

Equity thoughts: Two weeks ago, in the Asset Allocation Weekly, we touched on this issue of politics, focusing on the potential impact of political polarization on Fed policy.[1]  In that report, we noted a chart on political polarization that we show again below.

(Source: Rosenthal and Poole)

This data reads as follows—the higher the level, the greater the degree of polarization.  Our position has been that deep political divisions are the norm and the decline in polarization that began at the turn of the last century that accelerated into WWII is the outlier.  The pressures of the Cold War and the outside enemy of communism functioned as a unifier.  Soon after the fall of the U.S.S.R., polarization returned with a vengeance.

For financial markets, political polarization isn’t necessarily bad.  If it results in gridlock, legislative and regulatory policy tends to remain stable and leads to conditions that are supportive for investment.  But, in a nearly equally divided society, there is a certain attractiveness to jettisoning the restraints of the constitution and democracy.  We have seen this tendency before.  In the two decades before the Civil War, Congress more resembled an open brawl.  Are we there yet?  Although members are not openly fighting, the crowds around them certainly are.

It is rare that a market decline not tied to a clear financial event (major financial firm failure) or geopolitical event (war, major terrorist act) can be pinned to a single reason.  Given that caveat, what happened yesterday was, we think, due to a combination of events:

  1. Fed tightening: The trading pattern in equities since 2009 has all the look of a secular bull market. However, previous secular bulls have occurred, in part, due to the perceived resolution of serious economic or societal problems.

Each one of these previous secular bulls coincided with a new consensus.  With regard to the last two, for example, the 1952-69 bull was due to the idea that policymakers had resolved the conditions that caused the Great Depression and equities rose with that fear resolved.  The 1982-99 bull was due to the resolution of the 1970s inflation crisis.  We haven’t added shading but if we did it would be around 2013, when new highs were made.  However, we doubt that any societal issues have been resolved.  The big issues, resolving the superpower role and addressing inequality, have not been fixed.  Instead, the bullish impetus was mostly due to very accommodative monetary policy coupled with fiscal and regulatory policy that favored capital.  If that is the case, the removal of monetary policy accommodation may be a much bigger negative factor than it normally would.

  1. Political polarization has become bad for business: As noted above, if polarization leads to gridlock, it isn’t necessarily negative. But, if polarization leads to violence and divisions make the nation ungovernable, this makes investing very difficult because the path of policy becomes impossible to determine.  Large demonstrations from both the right and left, the shooting of Majority Whip Scalise and the most recent bomb mailings are not conducive to a high P/E.
  2. Trade policy: The uncertainty surrounding trade policy is a concern. A key factor supporting corporate efficiency has been global supply chains.  It appears to us that one of the goals of the administration’s trade policy is to bring investment back to the U.S., which will boost employment but likely undermine margins or boost inflation.
  3. At the same time, it’s important not to overlook what is going well: Earnings remain very elevated. Yes, the growth may slow but the level is historically high.  The economy overall is still doing quite well.  There are areas of concern; housing is losing momentum rapidly.  But, even slowing to 2.5% growth isn’t bad.  Inflation, though somewhat higher, is still low especially given the length of the expansion and the low level of unemployment.  In the absence of political and trade uncertainty, we would likely have an S&P 500 around 3200 and we would be talking about a bubble. 
  4. The bottom line: History shows that market declines that don’t coincide with recessions tend to be short-lived and are usually buying opportunities. We suspect we are coming close to a bottom and would expect a recovery from here.  In addition, the post-mid-term election period tends to be quite bullish.

Odds and ends: The ECB meeting was mostly a non-event.  Policy may start tightening next year if conditions continue to improve.  China is cutting rare earth production, something it has done before when unhappy with foreign behavior.[2]  China appears to also be reducing its buying of Iranian oil in front of the November sanctions.[3]

View the complete PDF

[1] https://www.confluenceinvestment.com/wp-content/uploads/AAW_Oct_12_2018.pdf

[2] https://www.reuters.com/article/us-china-rareearths/china-cutting-rare-earth-output-unnerving-global-manufacturers-idUSKCN1MY2GZ

[3] https://www.reuters.com/article/us-china-iran-oil-exclusive/exclusive-sinopec-cnpc-to-skip-iran-oil-bookings-for-november-as-us-sanctions-near-idUSKCN1MY1C9