Financial Markets – When Tempting Tranquility Leads To Turmoil
The present coronavirus scare is evidence of how tempting tranquility can quickly turn into turmoil. It would be faulty to compare this recent epidemic originated in China (and the potential economic impact) to the effect of SARS on the global economy in 2003. After all, China represented a nine percent share of the global economy in 2003 compared to today, which is now more than double with a nineteen percent share. Furthermore, the Chinese consumer accounts for half of the growth in their economy, which will compound the global economic hit, per Dave Rosenberg. With an already fragile global economy, a worldwide epidemic (and the ensuing negative economic impact) could be the event that precipitates a global recession.
While the US equity markets experienced their weakest January since 2016, perhaps more interesting is that the yield curve has once again inverted (i.e. short-term interest rates are higher than long-term interest rates), which is often the precursor to some pain ahead. Keep in mind, the yield curve is still inverted despite our Federal Reserve reducing short-term rates three times last year! The Fed also flooded the repo market with liquidity, by acting as the lender of first resort rather than the lender of last resort (continuously co-opting the role of the banking system). This action by the Fed will eventually prove to be a flawed strategy as they do not have the ability to repeal the business cycle.
Dave Rosenberg recently stated, “In 2020, I smell a rat.” Not coincidentally, the rat in this case has emerged in China, although this has more to do with reality (and perhaps gravity) setting in. Fundamentals have been deteriorating with slowing corporate profits (last experienced in 2015), and capital spending increases being put on hold. Furthermore, some companies have been inflating earnings by buying back shares with borrowed funds, as their senior management teams have been focusing exclusively on beefing up their current compensation at the expense of their companies’ long-term value mandate. Of course, investors have willingly (and happily) gone along for the ride – enjoying the upward momentum while ignoring the fact that they are paying higher prices for lower organic earnings. As MacroMavens economist Stephanie Pomboy states, “The real information to be gleaned from the market is beneath the surface and at the margin.”
As January revealed, momentum can only last for so long before it becomes mean-reverting. We now suspect that the masked fundamental disintegration is rapidly becoming more evident. So, if wise Aristotle was correct when he assessed that “the least initial deviation from the truth is multiplied later a thousand-fold” – investors should take caution and proceed with a defensive investment strategy. Maintaining liquidity with a focus on reasonably valued, best-in-breed cash flowing companies, short duration high-quality bonds, and gold will be most important in 2020. As budget deficits continue, all roads will lead to more money printing. A recent edition of the Economist read, “John Pierpont Morgan, eponymous founder of America’s biggest investment bank, quipped that ‘gold is money, everything else is credit.’ And when the return for providing credit is close to zero, it is little surprise that investors want their money in gold.” While the price of gold has been correlated to the amount of negative yielding debt globally over the past five years (i.e. more negative yielding debt = higher gold price), there is currently a divergence. In addition to signs of higher inflation on the margin, this divergence could portend to higher inflation ahead overall, as the gold price has remained elevated despite a few recent months of decline in the amount of negative yielding debt. While not many market strategists are factoring in higher inflation, I would caution based on the old adage, “It occurs first very slowly, then all at once.”
The Rosenau Group is a team of investment professionals registered with HighTower Securities, LLC, member FINRA, SIPC & HighTower Advisors, LLC. This document was created for informational purposes only; the opinions expressed are solely those of the author, and do not represent those of HighTower or its affiliates. This is not an offer to buy or sell securities, and HighTower shall not in any way be liable for claims related to this writing, and makes no expressed or implied representations or warranties as to its accuracy or completeness.