State of the Industry Whitepaper
Part 1: Market Outlook
Volatility has been the hallmark of financial markets during the first two months of 2H19. Although investors warned that the geopolitical climate and decelerating economic expansion would pose significant risk factors, the looming US-China trade war has proven itself a pervasive threat. As the last month of 3Q19 begins, it’s evident that escalating trade tensions will remain a focal point through year-end.
Following the G-7 Summit in late August, market players were optimistic that the two economic powerhouses would ink a deal and stave off the impact of tit-for-tat tariffs. However, the hope of an agreement quickly soured as the start of “Bad News September” saw both the US and China follow through on plans to enact new tariffs.
As of September 1, the US implemented 15% tariffs on approximately $111bn in tools, apparel, footwear and certain electronics. Plans to levy an additional 15% on $156bn worth of goods—which include toys and electronics like video games, smartphones, laptops—will be postponed until after the December holiday season. Retaliatory tariffs by China, which also took effect September 1, target agricultural goods, crude oil and pharmaceuticals.
While US President Donald Trump took to Twitter to announce the success of his strategy, Head of Internal Affairs at the US Chamber of Commerce, Myron Brilliant, opposed the president’s negotiation style. According to him, Trump’s tactic of endless escalation will cost the average US household $600 to $1,000 by year-end. Likewise, JP Morgan has estimated the average household will pony up an additional $1,000, and in May the Federal Reserve Bank of New York estimated that existing tariffs would cost households an additional $831.
While the trade war has not shown signs of fizzling out anytime soon, Geng Shuang, spokesperson for China’s foreign ministry, said during an August 30 briefing that US-China trade delegates were communicating effectively and aiming to ink an accord this month to stave off further escalation. However, should talks fail to resolve the deadlock this month, Trump intends to press onward with escalation: the existing 25% tariffs on $250bn worth of goods are slated for an increase on October 1, when the US will implement 30% rates.
Data indicates that the long-term impact of this spat will reverberate throughout virtually every level of the economy. Labor Department figures compiled by Goldman Sachs show that since February 2018, the price of goods affected by tariffs has increased 3.29%, while the price of core goods unaffected by tariffs decreased .97% during the same time period. The Congressional Budget Office projected that the trade war will reduce the level of real US GDP by 0.3% while reducing the average real household income by $580. For China’s part, it’s facing the slowest economic growth rate in years, and the trade war will continue to take its toll on the country’s expansion.
While the investment community hopes that the high stakes are a sufficient motivator for the US and China to end this impasse, we’ve seen this play out before. Since May, negotiators have allegedly been on the brink of penning an agreement multiple instances—China reportedly agreed to purchase more US farm goods in exchange for the US easing restrictions on Chinese tech giants—only to have the bottom fall out every single time.
The trade war is only one facet of the geopolitical uncertainty that has been a key driver of market turbulence throughout the summer. Ongoing protests in Hong Kong have been at the center of turmoil for two months and have taken a particular toll on the airline sector, as protesters have overrun the city’s transportation hubs and shut down airports on multiple occasions. In Europe, Boris Johnson is vying to push a no-deal Brexit through by any means necessary, and Italy is in the throes of overhauling its government.
The confluence of all these factors has ushered in a phase lacking historic precedent. Roughly two weeks after the Fed implemented a quarter-point interest rate cut, the 2-/10-year yield curve began dipping in and out of inversion during the latter half of August and reached its worst level since 2007 on August 27, leaving economists and strategists split over whether global markets are doomed for an impending recession.
As CBXmarket’s in-house investment expert notes, with more than $16tn in global government debt yielding negative and risks related to China, Brexit and the Fed creating a perfect storm, there are particular market movements within the last decade—namely, the 2016 Chinese stock market crash, the original Brexit vote and 2013’s “taper tantrum”—that provide unique cases to compare and contrast as the investment community seeks to understand the market and forecast what to expect in the coming months.
Chinese market turbulence
All of the S&P 500’s 11 sectors traded in the same direction during 11 straight trading sessions in August, which was the highest monthly incidence of such alignment since January 2016, when China was suffering a stock market crash. Amid a widespread selloff at the time, fears regarding the Chinese economy took its toll on commodities as falling oil prices underpinned concerns about disinflation.
Global equities were vulnerable, and during the rout, the Dow Jones and the S&P 500 lost roughly 5% of their value in a week’s time, leaving hardly a sector unscathed. But, it didn’t happen overnight. The writings were on the wall months earlier—partly the result of a heavy-handed interventionist approach by the Chinese government, which resulted in risky margin lending and left consumers exposed—after a period of prolonged volatility. In fact, the market turbulence began in June 2015, merely a day after the Chinese stock market reached an all-time high.
The burst of the Chinese equity bubble resulted in the worst single-day drop for the Shanghai Composite in eight years, and was dubbed “Black Monday.” It didn’t stop there: the Eurofirst 300 experienced its worst day since 2009, while the German DAX wiped out all the gains it had made in 2015.
Today’s international panic harks back to that time. Treasuries have collapsed as equities decline, triggering a selloff of emerging market currencies and pushing investors to de-risk in gold. As global stocks teeter on the brink like they did this time four years ago, strategists predict markets will have to worsen before Trump switches his approach to foreign policy.
(Source: Wall Street Journal)
The 2015 rout hit commodities hard: oil fell to a 6.5-year low, and at the time, a Bloomberg commodity index had reached its lowest level since 1999—even gold declined as investors who used it for collateral were “flogging it to meet margin calls.” Only government paper from the US and Germany offered a welcome refuge for investors.
At the time, Chinese manufacturing shrank at its fastest pace since 2009, while the People’s Bank let the renminbi fall by nearly 2%. Now, new data from the National Bureau of Statistics shows Chinese manufacturing is once again contracting, as are exports, and further tariffs will continue to have a detrimental impact on China’s manufacturers. American companies will also bear the burden, and as many US businesses seek to move manufacturing out of China to limit their exposure, they’re tasked with finding sophisticated supply chains elsewhere.
Weakness in China’s manufacturing sector has contributed to the decline of Asian stocks and US equity futures, and the month ahead is unlikely to offer much hope: since the 1950s, September has been the worst month for the S&P 500.
All Eyes Remain on the Fed
There’s speculation that the decline in global equities could force the Fed’s hand into slashing rates by 50bp later in September. Investors will be closely monitoring the agency for any signal from Chairman Jerome Powell regarding monetary policy changes. After announcing a highly anticipated rate cut in July, investors were left wanting, disappointed that Powell didn’t imply aggressive easing would be forthcoming. Adding insult to injury, Fed policymakers declined to offer any indication about the agency’s stance during last month’s Jackson Hole meetings.
Powell and his ilk must strike a delicate balance of reassuring the investment community that central banks are attuned to their needs, while communicating that stance without alarming the markets.
Earlier this summer, ECB President Mario Draghi spooked the markets and disappointed equity bulls in June. After hinting at a stimulus injection should European inflation figures fall short of targets, he sparked the largest single-day fall in years for both US and Eurozone yields, as French 10-year rates turned negative for the first time ever and Germany’s 10-year hit record lows.
Global government paper has continued its downward trend in yields. Several European Central Bank members offered hawkish commentary last week, and over the weekend, certain policymakers added fuel to the fire after exhibiting skepticism over the need for a large stimulus package this month.
As uncertainty continues to cloud the outlook for the rest of 2019, central bank heads must take care not to misspeak or misstep. When former Fed Chairman Ben Bernanke botched policy remarks in May 2013, after suggesting that the US central bank would reduce its balance sheet—cutting back on its $70bn of monthly purchases in bond and mortgage-backed securities—citing a strong economy, he triggered a global “taper tantrum,” and sent the markets into a tizzy. In the aftermath, stock prices fell while global bond yields skyrocketed: The 10-year US Treasury rate was 1.94% the day before the testimony and reached 3.04% by December 2013.
On the Brink of Brexit
Beyond Fed policy and trade war woes, investors will be waiting with bated breath to see if “Bad News September” extends to the geopolitical arena in the UK. With Prime Minister Boris Johnson at the helm, the markets could be bracing for a no-deal Brexit, a move that has been hanging in the balance for more than three years.
Going tête-à-tête with his opposition, Johnson’s agenda for the remainder of 3Q19 will be choreographing a game plan for Britain to leave the EU once and for all. In late August, the queen granted Johnson’s request for a prorogation—a formal suspension of the parliamentary session—slated to take effect September 12. The ploy diminishes the amount of time that opposition MPs will have to halt a no-deal Brexit, as the October 31 exit date quickly approaches.
When the Brexit referendum first rocked the markets in June 2016, it ushered in the worst market day since 2011—the Dow suffered its eighth biggest drop ever, and global equities were hammered: the STOXX Europe 600 had its worst day of record since 1987, and the German DAX since 2008.
The USD gained 12.5% against the GBP, and the US 10-year Treasury rate fell to lows not seen since 2012. Investors sought safety in the long end of the yield curve, and global 10-year rates trended downward: the 10-year fell 44bp in the UK to 0.934%, 31bp in the US to 1.44%—breaking negative in the EU—21bp in the EU to -0.116%, 5bp in Japan to -.19% and 21bp in Canada to 1.08%.
One week after Brexit, 10-year yields continued to hit record lows, and in the following month, the 10-year US Treasury reached 1.32%, its lowest point ever, before rising again after the election of President Trump and ending the year at 2.45%. Though government paper in Greece, Italy, Portugal and Spain saw yields rise, the contagion spread like wildfire.
If Johnson is successful in pushing Brexit through in the coming month, it will beg the question of whether the global markets are doomed for a repeat. As geopolitical risks hamper the global economic growth outlook over the short-term, uncertainty appears to be the only certain thing.
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