Daily Comment (September 5, 2019)

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT]

Trade optimism is lifting risk assets; equities are up, while gold, the dollar and Treasuries are down.  Here are the details and other items we are watching:

An observation:  One of the most difficult tasks humans face is trying to deal with low probability/high impact events.  If something can happen that is highly unlikely but extremely positive or negative, our minds tend to become a muddle.  This situation explains why lotteries flourish; anyone with a modest understanding of basic statistics realizes that a lottery is a voluntary tax paid by those who fail to understand how the numbers work.  And yet, money is wagered 24/7 in these long-shot bets.  Anyone who has raised teenagers can see this problem work out first hand.  Teens will take completely unnecessary risks for inconsequential benefits and then be shocked when the unlikely outcome occurs and causes an expensive consequence.[1]

Financial markets struggle with this issue constantly.  In fact, we have options markets available to give us tools to deal with these circumstances.  Nicholas Taleb has made a career out of making small wagers on unlikely but very consequential events that occasionally pay off enormously.  Still, most of the time, the unlikely event doesn’t occur and we, like the teenagers we once were, go our merry way.

Today is an interesting example of this situation.  Equities are up sharply on hopes of a trade deal with China due to the news that the two parties will meet in October.  Although there is hope that something might come of these meetings, positions have hardened and anything beyond a truce would be surprising.  This isn’t the only situation that may be improving.  A hard, Halloween Brexit appears unlikely as PM Johnson has suffered a series of electoral defeats.  Like a cat playing with a mouse, Jeremy Corbyn continues to delay the inevitable general election, keeping Johnson in Downing #10 with little power.  In Hong Kong, the fear was an invasion of the island by the PLA; instead, we are seeing grudging concessions that probably won’t stop the protests completely but will likely reduce the intensity over time.  And, in Italy, fears that the League would gain control and trigger a Eurozone crisis have been eased by a new leftist government.

Market strategy, in part, requires one to look out for what can go terribly wrong.  At the same time, there is a realization that, most of the time, things work out ok.  Unfortunately, the longer things work out ok, the more complacent we become.  Hyman Minsky noticed this issue, dubbing it the “financial instability hypothesis.”  In effect, the longer conditions remain stable, the more investors are inclined to take more risk, eventually creating conditions where a financial crisis cannot be avoided.  It’s a bit like forestry management that never allows a fire to develop.  Over time, the underbrush that would normally be reduced by small fires becomes so thick that a small fire becomes a big one.  Our industry is characterized by Cassandras who are always projecting the end is near, along with permabulls who assume everything will always be ok.  What we try to do, as is likely true with most strategists, is hew a path between these extremes.  Most of the time, the worst is avoided; but, when the worst occurs, “it leaves a mark.”  In some respects, holding to either extreme is intellectually easy.  Cassandras are wrong most of the time, but when they are right their calls appear to be spectacular.  Permabulls are right most of the time, but it can feel like they are “gathering nickels in front of freight trains.”

So, where does all this leave us?  Although trade talks with China may bring us to a truce, we don’t think that China is going to fundamentally change its approach to trade and there isn’t much evidence to suggest that President Trump sees much risk from his trade policy.  To the president’s credit, he has concluded that China is a strategic competitor and so, regardless of the outcome of the current round of talks or who wins the White House in 2020, our relations with China are changed for good.  The U.K. is going off on its own; even if a new referendum rescinds Article 50, its relations with the EU will be forever fraught because of Brexit.  In addition, the Brexit debate has exposed societal divisions that plague not only the U.K. but the West, in general.  Hong Kong is eventually going to come under control of Beijing and its current freedoms are likely to be lost; capital and human flight are likely.  This outcome not only affects Hong Kong but Taiwan as well; if anything, the protests in Hong Kong may have increased the odds that Taiwan won’t rejoin the mainland peacefully.  Italy has suffered during its tenure in the Eurozone; either Germany changes its export-driven economy or Italy will need to leave the Eurozone at some point.  Today, it looks like these potential crises have been averted, and if this optimistic sentiment continues, we will likely challenge the recent highs in the equity indices.  However, the structure beneath has not changed.

In the PBS drama Doc Martin, Luisa, the nurturing, lovely wife of the curmudgeonly Doc Martin, purrs to a frightened young girl:

“No one’s going to die.” Martin, as affectless and socially clueless as always, counters, “Yes you are. Everyone’s going to die.” Before adding, “But not today.”

This line is a decent reflection of what investors face; there are a myriad of low probability/high impact events that can occur that would have either a very positive or negative impact on one’s portfolio.  This is the business we have chosen.  Our take on events?  As we have been saying, it’s too early to take an overly defensive stance in portfolios but the time to do so is probably on the foreseeable horizon.  Stay tuned…

U.S.-China Trade:  The United States and China have both confirmed that their top-level trade negotiators – Chinese Vice Premier Liu He, U.S. Trade Representative Robert Lighthizer and U.S. Treasury Secretary Steven Mnuchin – will meet again in early October to try to resolve the countries’ trade dispute.  Lower-level officials will meet in September to prepare for the meeting.  The prospect of further meetings offers a glimmer of hope that the trade war can be reversed, so risk markets across the globe are rallying today.  However, it’s important to remember that the countries remain fundamentally at odds on their trade goals, so there is limited hope for meaningful progress at the talks, even as the dispute continues to weigh on global investment and trade.

Hong Kong:  Municipal Chief Executive Carrie Lam said today that she alone made the decision this week to formally withdraw her controversial China extradition bill, which sparked the massive political protests of recent weeks.  While that decision has been taken as a positive, prompting a surge in Hong Kong assets yesterday, it’s important to remember that she also insisted that to “withdraw” the bill was substantively no different than her decision to “suspend” it earlier in the summer.  The withdrawal announcement was already being taken as too little, too late by many protest leaders.  If Lam’s statement is now taken as confirmation that nothing has really changed, there’s an even greater chance that the protests will continue, which would probably weigh on Hong Kong stocks again.  That’s especially true if it looks like the government and police continue to clamp down on demonstrators, sometimes apparently working with organized crime groups to harass them.  Today, masked assailants threw Molotov cocktails at the home of media mogul and democracy activist Jimmy Lai Chee-ying.

United Kingdom:  You know things are going badly when even your family abandons you, and that’s what has happened to Prime Minister Johnson today.  The prime minister’s brother, Jo Johnson, announced he would leave his position as universities minister and give up his seat in parliament to protest the government’s headlong drive toward a no-deal Brexit.  The bill requiring the prime minister to ask the European Union for a delay in Brexit completed its passage through the House of Commons last night and is expected to get through the House of Lords by the end of Friday, allowing it to return to Commons on Monday.  However, a spokesman for Prime Minister Johnson said he will not make the request to the EU even if the bill becomes law.  Having lost any hope of blocking that bill, the Johnson government is pushing for a new election in order to secure a mandate for its Brexit policy, but yesterday parliament also voted against snap elections.  In a final blow, influential Conservatives are pressuring Johnson to reinstate 21 legislators that he purged from the party yesterday for voting against him on the measures.

Eurozone:  In testimony related to her nomination as the chief of the European Central Bank, yesterday Christine Lagarde said Eurozone governments should adopt stimulative fiscal policies to accelerate economic growth.  Lagarde insisted that “central banks are not the only game in town” and she is not a “fairy” who can magically prompt greater growth through monetary policy alone.  We still don’t see a lot of movement toward greater use of fiscal policy to promote economic growth around the world, but if the trends toward economic sovereignty and populism play out as we expect, we do think greater fiscal stimulus will be more widely adopted down the road.

Italy:  Yesterday, the new Democrat-Five Star coalition government announced its lineup of ministers, and the appointments suggest there will be fewer disputes between Italy and the EU over the country’s budget deficit, debt and migration policy.  Importantly, the new finance minister, Roberto Gualtieri, is a member of the center-left Democratic Party who previously served as the chairman of the economic and monetary affairs committee in the European Parliament.  Even if Gualtieri pushes for new spending or tax cuts to boost the economy, as the Five Star Movement will demand, we think EU leaders will be more flexible with him than they were with the more combative previous coalition composed of the Five Star Movement and the far-right League.  In sum, the developments in Italy are now looking more supportive of European risk assets.

Sweden:  Although yesterday the Riksbank held its benchmark short-term interest rate unchanged at -0.25%, its policy statement reiterated that policymakers soon plan to start hiking rates again.  The projected rate hikes would be milder than previously planned, but the policy stance is at odds with most major central banks.  That’s at least partially explained by the recent weakness of the krona and the general outperformance of Scandinavian economies in recent years.

Argentina:  Some of the country’s largest international creditors held informal discussions this week on President Macri’s proposal that they “voluntarily” accept delayed repayment on some $100 billion of government debt.  Most importantly, the participants agreed that any debt deal would require a commitment from Alberto Fernández, the populist leader of the opposition Peronist party who is currently the frontrunner in the upcoming presidential elections.

Central bank issues:  Although financial markets in Europe and the U.S. continue to project aggressive easing by the Fed and the ECB, internally, there is growing opposition to taking strong actions.  Yesterday, we noted the differences between Jim Bullard and Eric Rosengren.  Today, we see there are elements within the ECB opposing Draghi’s plan for stimulus.  A divided Fed will likely lead to a modest rate cut later this month, not the more aggressive action discounted by the financial markets.

View the complete PDF

[1] Yes, this did happen to us.  It involved an unnecessary decision to drive at night and a deer.  Enough said…