December 2018 Newsletter Part II: The Major Market & Economic Risks 2019 😨
Making Money in 2019 IS going to be a LOT different
Volatility is Creating Opportunity and Testing Our No Recession Conviction in 2019 Part II
OK--as my new best friend Chris Cuomo says "Let's get at it!" I would encourage you to PRINT this Part II of our year-end December 2018 Transformity Investing PRO newsletter. I guarantee you are going to want to refer back to it more than a few times as we navigate the minefield of risks to the American and Global economies in 2019 because they are now interrelated and getting correlated.
In Part I, I asked the only question that really matters for equity and debt investors in 2019:
1) Are we at the beginning of an oncoming 2019 US recession and a REAL 30%+ face ripping bear market after a historic 10-year bull market? Are the 800pointfailed rallies and melt-ups proof we are in 2019recession anticipatingbear market (because the hallmark of bear markets are historic short covering rallies) and the US/China Trade battle turns into a cold war while Fed has once again killed the stock market with an over-tightened monetary policy recession soit's time to be 100% defensive or
2) Are we in a very badly needed and healthy 20% ish price correction/reset of over-baked tech stock valuations to reflect a deceleration in 2019 GDP growth to a 1.5%-2% GDP economy (from 3%+ in 2018) and a deceleration to 4-5% EPS growth S&P 500 in 2019 from the magical late cycle 25.5% year-over-year EPS growth in 2018 (thanks to the 40% cut in corporate tax rates)
Our conclusion has not changed in 2 days; the forward-looking data says we are not headed for a 2019 recession (with the caveat that we get at least a truce with China by March 1 and the Fed on additional rate hikes till June) thus this correction is a market event (i.e., a function of negative market mechanics/tax selling/80%+ algorithmic momentum trading being reversed) that brings us the third 20%+ correction in this aging 10-year bull market but the business cycle expansion extending into the first half of 2020 and not ending in the second half of 2019.
I also said that those in the "bear market has started and the 2019 recession-is-coming in 2019 camp believe that A) the Federal Reserve made an irreparable policy tightening error (and will not taper back the $50 billion a month in capital liquidity removal or end Fed Funds rate hikes) B) The China Trade War is not going to come to a meaningful truce by March 2019 and this trade war turns into a cold war which has a very significant negative impact on global economic capital and intermediate goods demand and C) a US recession in 2019 starts by July and not July 2020 as we forecast.
Now Lord knows, we have at least a dozen very real risks to the market in 2019. ANYONE of the top 5 risks would change our forecast and kill the wounded bull market. So let's get into the Top Equity & Economic Risks in 2019. They need to be identified, analyzed, measured.
But before I get there, let me add a few comments and new observations on why this latest 20%+ bull market correction was so crazy and so idiosyncratic for the post-Thanksgiving/December markets in history.
1) As I mentioned in Part I, when the world Central Banks created $15 trillion in liquid assets for the world's banks and institutional investors (from their "Quantitative Easing" monetary policy of buying $15 trillion of Treasury bonds/mortgage securities and in the case of Japan and the EU corporate bonds and stocks with their imaginary out-of-thin-air cash) and that cash now sitting in the accounts of the institutions that sold those securities to the Central Banks mostly got deployed into...other financial assets.
But the real point here is "where did that cash go?" In a highly integrated $30 trillion equities market and $70 trillion world debt market, investors from all over the world came to roughly the same conclusion starting after Brexit and the EU economy started slowing: the United States, with rising rates of interest on no-risk US Treasury bonds (vs. negative yield Yen bonds or drastically lower EU/UK bonds) and a 40% corporate income tax cut in late 2017 was the "last man standing" and the most attractive investment location in the world.
I mean really--what government enacts $1.5 trillion of unpaid for fiscal stimulus into a $20 trillion economy in the last few innings of a 10-year expansion, right? What country would borrow $1.5 trillion to stimulate their economy and explode their deficit spending and borrowing to $1 trillion a year for the foreseeable future? Isn't that what you do to turn around a recession? When did the fiscal stimulus playbook get changed for the government to juice its economy after 10 years of expansion?
Well, it, of course, turned out they were right! 27% gain in the SP 500 in 2017--and after the 2018 February correction another 16% run. And oh daddy relative to the oncoming bear markets for equities and negative returns on bonds/cash in the rest of the world--the Dom Perignon Fois Gras was flowing.
But now, upon review of all the data and a few phone calls, my base case scenario now for this August/September melt-up and resulting flash crash correction is simple: 1) AS these global investors started piling into US assets, the recent strength of the American economy created a positive feedback loop, and this piling into US assets pushed up the USD exchange rate (because they had to sell Euro/Yen/Pounds to buy dollars to buy US financial assets in dollars), which resulted in positive momentum for the US dollar starting in 2018 and proved negative for the EU/Yen and UK. Then...the dollar currency gains further pushed up the returns on US equity prices for investors getting appreciating currency vs. the currency they sold to buy those assets.
In other words, subjective belief became objective reality—that is what we call market reflexivity (check your Part 1 “Final Word” for the explanation of the term "reflexivity".) The market believed the Fed and GOP Corporate Tax Cuts gave them no-brainer profits vs. the EU or Japan on their way to a recession (and as I remarked in late August--they all thought the China trade war would end after Trump et al completed the new NAFTA deal because NO ONE is stupid enough to snatch defeat from victory by creating a trade war with the largest exporting country in the world.)
With the US market now up to 85% volume traded by momentum algorithms, this positive price feedback loop got a booster engine from the algo machines and risk parity rules based investor (who were losing money on their leveraged bond portfolios so they sold bonds to buy stocks) into September and then BOOM POW!
While we had taken massive multi-year profits on our semiconductor-related positions by early September and were sitting 75% in cash/high yield ETFs/ETNs, the Fed Chairman in early October said “#1 the Fed was NOT close to the end of raising short term rates to the magical “neutral” rate and oh yea “the Fed was now going to start burning off $50 billion a month in their bond portfolio instead of the $20 billion rate per month rate (which I now calculate to be the equivalent of tightening monetary policy by 65-80 basis points a year or about 1% ON TOP of the 25 basis points per quarter Fed Funds rate increases.)
In short, the Fed was already PAST the friggin "neutral point." I am sending my model to the Nobels.
OMG—long equity investors using borrowed money shit the bed—they would now have to revalue equities discounting a much higher discount rate and the Fed did NOT have their backs any longer.
Why did the Fed not have their back any longer? After all, since 2008 the Federal Reserve had everyone’s back by waiting till 2017 to slowly raise real short-term rates (still below zero after you subtract 2% inflation) and slowly running-off some of its $4.5 trillion in bonds ($10-$20 billion per month--no whoop in a $70 trillion bond market). Remember that after 2008, the Fed became the world's emergency supplier of “convexity” -- the fancy term for asset downside protection -- after the capital markets locked up from the Lehman/AIG bankruptcy and badly mispriced illiquid and complex derivative assets like callable bank loans, mortgages, credit, CDS, and structured products which made most major American and all European banks technically insolvent.
What really is happening today technically is the Fed is slowly shedding its role as “convexity supplier of last resort” in favor of stepping back and managing convexity as needed. Thus the Fed’s impact on markets and the notion that the central bank “put” which has backstopped risk-taking had to be repriced into risk assets since, by definition, the defender of risk assets was now not defending them nearly as vigorously.
The end result? RISK OFF! In short, the world (and not just US investors) were ALL now in a very crowded long trade in the SAME high-beta (highly volatile) technology hardware and software-as-a-service stocks and they ALL panicked when their Sugar Daddy told them "you're on your own" and they ran for the same exits at the same time.
THAT is why there was no “dip buying”—the algorithm's buy-the-dip recipe’s failed at the usually winning 50-day/100-day/200 moving average dip-buying support so then they just flushed their biggest winning stocks and bought cash.
Then in early December, after changing the tone and saying "we are very close to neutral" (gee--what happened between Oct 3 and Dec 9th ????), Powell plunged a sword into the remaining longs with the “yea our $50 billion of bond sales per month are on auto-pilot” comment and SWOSH!
Remember, we are in truly uncharted Central Bank waters here. There has never BEEN $600 billion of “auto-pilot removal” of capital liquidity removed EVER in any market. Since 2010-2017 there was the reverse—the Fed started out with a $650 billion balance sheet into the 2008-2009 crash—by 2017 they owned $4.5 trillion of bonds (which meant since they paid cash for those bonds they had injected $4.5 trillion into the U.S. economy) along with the Bank of England, EU Central Bank, and Japan adding another $11 trillion in "quantitative easing" aka QE.
Again—nobody KNOWS what really happens when this reverses but we do know this: when you increase the Fed balance sheet $4 trillion and consider that activity to materially stimulate economic growth by increasing financial asset values, but then say that draining $50 billion of market liquidity is on “auto-pilot” and won’t have material impact on economic growth—Dude it can’t be both!
That statement unleased the “Equity Vigalantes” to paraphrase my old friend Ed Yardeni and his term for those who short the bond market when governments let inflation get out of hand aka the“Bond Vigilantes.” All I can say is if last week’s reaction in the financial markets did NOT get the FOMC attention, nothing will.
And my bet is a ner 400 point move in the S&P 500 is why Secretary Mnuchin called in “The Open Market Committee” which is a euphemism for “OK Fed—time to calm the fu$#%$#k down here and do NOTHING for 6 months ok?”
The latest BAML Fund Manager Survey confirms those observations. Global managers believed that the US has the best growth potential of all the regions around the world. Look at the over-weight US positions. They were ALL caught over-weight US stocks with borrowed money and their hand in the proverbial cookie jar. When the musical chairs music stopped (to mix metaphors) there were not enough seats and the weakest hands were stuck while the big whales closed out.
More proof? Global Hedge fund performance in 2018 is DOWN 8%--gee I thought those geniuses made big MONEY in "volatile markets?" Can you say year-end redemptions?
Now this trade is getting unwound and because of forced margin selling. Fortunate for us sitting on so much cash there now ARE serious "dislocations" aka securities selling seriously under their net asset value because of the forced selling (more on those opportunities later).
Final 2018 Flash Crash driver--the new year-end liquidity rules for major banks in the US. These are the "globally systematically important banks, or G-SIBs, that are required to show regulators the state of their balance sheets as of Dec 31. They have to pay $billions in surcharges if they come up light--so what do you think they do? According to JP Morgan, "they do less of their normal business--including stock and bond market making aka providing market liquidity--heading into the end of December! This is idiosyncratic to the US but talking and texting to trading desk friends I got the comments "man I could not get a market bid on anything on those flash crash days."
You can't make these unintended consequences up.
Key point: Deep breath. We are in the last 1-2 innings of the economic cycle. What I mean by that statement is we assume that with the Open Market Committee meeting the Doves (aka the FOMC members that see the Fed tightening too fast) and the Open Market meeting will gain control of the FOMC vote and vote for a "time-out" and cut the "$50 billion auto-pilot" language on January 30th meeting to "data dependent" and comprehend the near 400 S&P 500 market drop as another very real monetary tightening event and sit on their hands till June.
The ultra-strong dollar short squeeze will also get the Fed to cry uncle very soon to preserve the expansion until the 2020 elections. Already the US Dollar Index (the doller vs. other major currencies) has rolled over as foreigners SELL US dollars from their equity market sales to buy Euros/Pounds/Yen. That falling dollar will help US global companies (38% of S&P 500 revenues come from abroad) and falling dollar with ALSO put a floor under commodities and energy prices (Note: because oil and most commodities are denominated in dollars, a weaker dollar makes oil cheaper and more attractive to all other currencies. That lower price helps stoke demand for crude, so when the dollar drops, oil prices tends to rise.)
As mentioned previously, I believe that Mr. Trump knows resolving the China Trade war before 25% tariffs kick-in in March is the ONLY way to keep this market event correction from becoming a full-blown, recession anticipating 30%+ bear market. For his profound vanity and sociopathic need to "win" and applause alone, my bet here is he realized he HAS TO end the war, declare “total victory” and remove the specter of a real cold war and trade tariff war with China. Otherwise, his entire sales pitch of increasing prosperity to the 60% of voters who do not approve of his “chaos and tweet” approach to running the Federal government is gone and he faces an embarrassing landslide loss in 2020.
So either way, the Fed HAS to get more dovish and turn down the $50 billion a month in auto-pilot quantitative easing and Trump has to follow his Trumpian playbook and get a few trading agreement changes (ones that were IN the TPP agreement he canceled of course) and proclaim "The largest trade deal in the history of the world."
Or you choose to commit political and economic suicide--over-tightening monetary policy while borrowing $1 trillion a year and for the second time in US history be the President that uses tariffs to drag down the world economy into a full-blown tariff war and global recession (or worse since the world does have $70+ trillion of debt outstanding and a LOT of that debt denominated in dollars) all in the name of "Making Murica Great Again."
The Major 2019 Market Risks
1) Algo-driven, risk-parity driven fire sale in equities and credit continues
Comment: With the Fed slowed down and the Trump Administration knowing it's in their hands whether the US economy recedes in the last half of 2019, right now the path of least resistance is to NOT purposely tank the U.S. economy or the 2020 elections for the GOP in the name of "MAGA".
Yes, I am making a bet that the mercurial Mr. Trump will do the right thing eventually--very Churchillian no? I just can't believe he will knowingly tank the markets (and of course blame the Fed which then further ties their hands) when it is in his power to prevent the world's recession coming to the United States and NOT create a negative global economic feedback loop.
What is the evidence we are right: the SP 500 and Nasdaq Composite reverse their "death cross" negative price momentum and the indexes crawl back over 200-day by the end of February. Q4 earnings are steady and Q1 guidance reasonable but with cries from CEO's that we HAVE to resolve the China Trade battle and keep it from becoming an all-out tariff driven war. Odds: 70% but we will be resetting these odds weekly.
Action to Take: We will be putting out some opportunistic safe and sane plays while the markets sort out whether the POTUS is willing to commit political suicide and dump the world into a full-blown recession. We WILL BE buying put options with April expiration to profit if self-emulation is the POTUS decision. BTW--ironically Chinese stocks will the biggest beneficiary of the turn we expect in US policy--companies with real sustainable earnings have been crushed 35-70% during this bear market.
Major Risk 2) Slowing growth in China, Japan and Europe (especially Germany) bring their recessions to the US economy
Major Risk 3) Slowing growth in China, Japan, and Europe triggers significant US dollar appreciation.
The tariff wars have already done significant economic damage to the world's largest export economies. Why? Because while tariffs imposed by the United States and China’s retaliatory tariffs have had very little direct impact on US GDP growth, the uncertainty over trade war has cut deeply into global corporate capital investment (“capex” plans.) While Brexit breakdown and Italian/Euro bank crises are definitely on the global trade risk radar, it’s the shrinkage in global capital goods demand that is driving the global slowdown and bear markets in export economies around the world.
How do I know this? Because the world leaders in export trade are now in GDP recession anticipating bear markets. Japan, the world’s third-largest economy, shrank at a 0.3% annual rate during the third quarter and is on track for 4th quarter negative growth aka recession (back-to-back negative GDP). Germany’s economy shrank by 0.2% during the third quarter, and government economists think that the fourth quarter will show negative numbers as well, leaving the world’s fourth-largest economy in recession, too. Sweden, Netherlands, and Switzerland also reported negative growth of -.02% during the third quarter.
Bottom line: The US/China Trade war leaves companies uncertain of where and when to invest.
Manufacturing managers are trying to work out whether to move Chinese production capacity to other Asian nations in order to avoid American tariffs, or whether to stay in China or do nothing at all. The uncertainty appears sufficiently pervasive to cause an economic downturn in some of the most trade-dependent nations. When in doubt, people sit on their hands and wait for the all-clear sign. In addition, the surge in US imports to the U.S. via China ahead of 30% tariffs (which ironically has EXPLODED our despised capital good trade deficit with China--who knew this would happen??) sets up for a significant slowdown in China Q2 exports even if the tariffs are lifted.
Overall world trade growth has slowed from about 5%-6% year-on-year to only 2% a year as of September, the last month for which data are published by the Netherlands Central Planning Bureau. And its heading south fast.
Forward-looking data suggest a steeper drop will follow soon, led by shrinking capital goods exports. German survey data show that the percentage of firms exporting higher exports during the next three months has fallen from 20%-25% at the beginning of 2018 to around zero at the moment.
BTW—Germany is the world’s second largest exporter, and is concentrated in capital goods. The US and Japan both have seen a marked slowdown in capital goods exports. And US imports and exports of capital goods (excluding autos) were growing at a double-digit clip earlier this year.
As of October, year-on-year growth was just above zero. And auto exports are flat year-over-year too.
Japanese export growth is now flat, too (see a pattern yet?)
Bottom line--without a rapid truce in the US/China tariff war AND the resumption of a bit of the Fed's convexity support, the world's recession becomes America's recession and the 2018 20% correction becomes a real 30% plus bear market as the United States goes below 1% GDP growth.
The 2010-2019 business cycle expansion is kaput/dead-and-buried killed by the economic illiteracy of a reality TV host elected POTUS and a Federal Reserve who has never ever had a $4.5 trillion balance sheet and has never had to remove $600 billion a year in capital liquidity from the $20 trillion for the domestic stock market. Trading volume in bonds also dramatically exceeds stock market volume, with nearly $700 billion in bonds traded on a daily basis.
So yes--the continuation of the 10-year US economic business cycle expansion and bull market for stocks has run out of monetary and fiscal tricks. We need an idiosyncratic, vainglorious, profoundly narcissistic, economically illiterate and delusional mercurial POTUS soon facing massive legal jeopardy to him and his family to keep his cool, end his economic war again China AND we need our Federal Reserve to "stick the landing" and not over-tighten its monetary policy after 10 years of monetary policy that has never been done before in the history of the modern world.
What could wrong eh?
Needless to say--we are monitoring ALL our macro and microeconomic data DAILY and while optimistic that real existential political and economic suicide is the strongest incentive to make these two very real and very powerful mistakes go away, I have learned to never underestimate both parties involved to snatch defeat from the jaws of victory.
The Final Word
We will develop trades for both scenarios (recovery and recession) but hold onto to our 20%+ yielding investments as this world-changing drama plays out. If our political and central bank leadership fails, US treasury bonds will explode in value as the worldwide recession makes US treasury debt the safety trade (for a while) and we will be geniuses. If our leaders come to the conclusion that economic and political suicide is not sane, we will be positioned to profit greatly.
But really--whatever your political stripes, when a country elects a reality TV star without a minute of government or geopolitical experience, I guess we should have expected we would get the ultimate economic reality show plot line eh?
Because the greatest risk to the American economy and standing in the world is that we have a mercurial POTUS who is untested in a REAL economic or geopolitical emergency. To be an investor in the American economy today, we have to believe that the institutions our economy and constitutional democracy are built on are the guard rails they were intended to be by our Founding Fathers.
The last "Tariff Man" we had as President tariffed the US economy and the world into the Great Depression. 800 mostly farm tariffs turned into 23,000 tariffs after all the special interests were done and American exports dropped 60%. Without an FDIC 70% of American banks went bankrupt. Without margin rules the folks who bought stocks with 10% down and 90% margin got wiped out and so did the banks and brokers who lent them the money. The US dollar tied to a gold standard and the Fed RAISING Fed Funds rates into the Great Depression didn't help either of course.
Herbert Hoover was a businessman before he became a politician, too. When the Great Depression moved past banks and Wall Street to Main Street, the federal government, of course, took in less money in tax revenues because of the bad economy and ran a deficit. Hoover tried to increase the government's revenues to balance the budget. He signed the Revenue Act of 1932, which was a large tax increase. He also signed the largest tariff (a consumer tax on goods that are traded between foreign countries and the United States) increase in American history which exploded the Great Depression, even though 1000 economists warned him not to do it using the negative economic history of trade wars and tariffs as their case.
Hoover also did something most do not remember. He denied giving promised retirement money to poor World War 1 veterans (called the Bonus Army) earlier than what was agreed to, so they went on strike. Hoover ordered the United States army to force them to leave. It resulted in a bloody conflict which hurt Hoover's reputation.
Hoover was uncharismatic and did not relate to the people well, which made many people consider him as mean-spirited.
Just saying. History does not repeat itself, but it sure does rhyme.
Happy New Year and hold ALL those profits tight!