Markets are jittery, and it is a real sign that market participants are waking up to the risks that have been present for some time. CheckRisk has been like a stuck record on the dangers associated with Breaking Unconventional Monetary Policy B.U.M.P. and so this piece focuses in on where clients should be positioned and why as the risk outlook is set to deteriorate in Q3/Q4. We also take a look at how the Fed and other Central Banks are likely to react to mitigate risk as it emerges.
As readers will be aware B.U.M.P. risks, include Geopolitical Risk, Synchronisation Risk, Trade and Currency War Risk, Economic Risk and lastly Central Bank Policy Risk. All of these risks form a network of risk that is connected by the creation of massive global liquidity since 2008. That liquidity makes things feel better; however, it is an illusion as its core is not based on strong economic performance but rather a historically high increase in debt.
So what is going on with markets and why? The MSCI World (Ex USA) has just touched a critical long-term technical threshold (MACD) that is indicative of a bear market. The intermediate signal (1-6m) also continues to break down. The USA maintains its long-term trend for the moment. Thus when one looks at the MSCI World including the USA the overall trend remains up and the trend intact. This hides the correct underlying position though, and risk is all about positional awareness. Positional awareness, a term that is widely used in professional aviation, is not just about knowing where you are in a physical sense. It is also about understanding in a three-dimensional environment where you are, what is changing, and how these changes will impact you. It is easy enough to do but surprising how few investors, boards, and non-executives take the time to consider where the investments or company is in the present moment. Instead, historical data is projected forward as if history repeats itself. CheckRisk has developed models like our Early Warning Risk System, Network Analysis, and human risk profiling systems to precisely avoid this human behavioural trap.
The USA has under Trump’s regime been on a spending splurge, on the other side of the coin this has allowed the Federal Reserve to tighten rates out of synch with the global economy who are still, for the most part, easing or finishing QE programs. The net effect has been an increase in overall debt levels, and some improvement in economic activity that has given the Fed the excuse to tighten monetary policy. There is a growing conviction that US monetary policy will continue to be US-centric and this could lead to a draining of that precious lifeblood liquidity from the global system. Interestingly China is not in a position to counter this without risking a crash in the currency and here is an example of how SYNC RISK is linked to CURRENCY AND TRADE WAR RISK. FED monetary policy is also out of sync with Europe, and the rest of Asia and these tensions are beginning to be expressed in other areas of the B.U.M.P. matrix.
The crazies are in town. Everyone knows that trade wars are a lose/lose, but somehow Trump and his coterie believe they can engineer a Win/Lose for the USA. (See our recent note on Trade Wars for more information) Trade sanctions are a severe issue because once the die has been cast, it is a devil of a job to regain the trust required to reverse and return to a sanction-free trade environment are likely to push inflation higher in the short term. Human behaviour mitigates against trusting the other person or entity, and this is one of the central tenets of game theory.
Current policies are leading to more substantial trade sanctions. The USA appears to be betting that China cannot react in terms of trade and will not react regarding currency for fear of a currency collapse. The problem is that if it gets too hot for the Chinese, they can start to sell US Treasuries and create pressure in the US Bond market. We are not there yet, but the Chinese are undoubtedly aware of their strength.
The reduction in Global Trade impacts two other B.U.M.P risks. Firstly, global bank cross-border flows, part of the Currency and Trade War group but also intersected with Global GDP. Secondly, Credit tightening feeds into Central Bank Policy errors and Global GDP.
Jerome “Jay” Powell the 16th and current Chairman of the Federal Reserve so far appears to be unconcerned about feedback effects regarding Sync Risk and Currency Risks. CheckRisk is carefully monitoring for a change in language regarding feedback loops, but to date, we have not seen any concern. As a result one of the most significant short-term risks is dollar and yield pressure on Emerging Markets causing a spillover into general financial markets.
The USA is on a nationalistic, domestic-based trajectory. The USA does believe it can move the goal posts and maybe they can, but it does have serious ramifications for the rest of the world. It is difficult to assess to what degree Trump has anti-Chinese feelings versus a calculated negotiation position. Trump’s advisors like Bolton appear to want a Chinese economic crisis as this would slow or halt the rise of Chinese hegemony in twenty years or so.
The problem with posturing is that you never know where you are going to end up. A posture turns into a position so quickly and the ability to miscommunicate mounts rapidly.
Brexit is a subject unto itself. However, on a recent visit to France and Brussels, it has become clear to CheckRisk that the EU is more concerned with Angela Merkel’s weakness in Germany and Italy as two existential threats to Europe. Brexit is languishing in third place, and the EU Commission meeting in June is not likely to come up with any significant advances mainly because the codification of what was agreed at the December EU commission meeting has yet to be finalized. Our view is that the risk of a hard Brexit is increasing and we believe that member states are preparing for that outcome while trying to encourage the British to come up with a coherent plan.
From a British perspective that is not such an easy thing to achieve. There is no real solution available for example with the Irish border question. The Conservative Party is dependent on the D.U.P, and no amount of pressure will force Arlene Foster and her team into accepting a border between the UK and Northern Ireland, whether it be physical or economic via the customs union.
It is important to note too that tensions are rising in the North. The risk of a return to violence should not be underestimated. A lot has been achieved since the Good Friday Agreement, but fragilities still exist just below the surface. It is one of the unintended consequences of Brexit.
For the record, we do not believe a second referendum is likely. It would be undemocratic by British standards no matter which way one voted. We also feel that the outcome of a second referendum may not deliver the answer that the Remainers and Europe desire. A candid French politician recently said to us
“if there was a referendum on Europe in France tomorrow we could not guarantee a remain vote.”
As a result, Brexit is not going well there is too much confusion and division in the UK political makeup to establish a coherent policy. CheckRisk feels that the opportunity to have a strong British negotiating position has been squandered and as a result, a poor outcome is almost inevitable.
At the same time, European politicians appear to have underestimated the risks of the UK crashing out of the EU. The choice has been taken that the EU can ride economic hardship but not the existential threat of other countries leaving the EU. The irony is that it is precisely economic hardship that has the potential to cause other member states like Italy to drop out eventually or to cause problems for the EU.
The next big EU fight is likely to be the Italian budget in August/September. If Italy decides to go on a spending spree, then this will be in confrontation with the EU. At present, it looks like the Italians are gearing up for just that.
Turkey has moved decidedly towards a dictatorship. Erdogan believes the President needs more significant control over central bank policy, thus threatening Central Bank independence. Turkey is right on the border of the EU and, as it has been historically, is a link between the West and the Middle East. Economically Turkey looks very vulnerable, and an economic downturn would impact the EU both from a trade perspective but more importantly regarding a net inflow of economic migrants. The EU’s borders remain porous for the moment, and there is no coherent cross country immigration policy that currently works.
It is clear that global risks are rising in line with CheckRisk forecasts of a period of elevated risk during between 2017-2020. Brexit occurs in 2019, and this will coincide with a natural economic end of cycle phase. Any of the risks above and others could act as a catalyst for a broader financial market correction.
At present, we feel the risks are being signaled, and so the Central Banks are likely to be able to manage any downturn for now. The Fed can manipulate the yield curve via a reverse twist; new QE can be introduced as well. CheckRisk has made a point that a downturn can be reversed; however, each “penalty save” made by a Central Bank weakens their ability to do more. More QE, therefore, is likely to be less effective and run into a shorter cycle of credibility. It is our view at present that the current market jitters are not the “big one,” but there is a risk they can develop into something bigger mainly if Central Banks do not react appropriately.
The tragic error is that the same misunderstandings that created the 2008 crisis are still pervasive today. Debt is indeed viewed as being ok, provided liquidity and the greater fool theory holds true.
Quantitative tightening does matter, particularly when trade sanctions, global trade, and cross-border flows are being impacted at a time of high leverage.
What is to be done?
For investors, it looks to CheckRisk like the US Dollar will remain strong. Treasury Inflation Protected Securities (TIPS) are likely to outperform Treasuries. For investors who are conservatively positioned the message is stick with it. For those who are not positioned for the risk environment, it is time to start taking the chips off the table. Unless the Fed blinks, it is likely that a serious risk will build in the coming months.
The underlying message must be to become positionally aware and move to a conservative profile wherever possible. To be clear, we are not forecasting the end of the world, just an increase in risk that can be avoided judiciously. We believe Central Banks and governments will move swiftly to soften the blow; however, there is an opportunity to de-risk now in case Central Banks make policy errors.
When the political crazies are running the café, it really is time to wake up and smell the coffee!
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