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A sharp move in US stocks, US Bonds and the US dollar yesterday signaled the beginning of the year-end rally

But Donald Trump’s Trade Wars may have derailed the world economy.

Yesterday’s soothing comments by the FED Chairman sent asset markets flying from extremely depressed sentiment levels.

Federal Reserve Chairman Jerome Powell opened the door for a potential pullback in projected interest- rate hikes for 2019 following a widely expected increase in December.

In what was seen as a shift in tone from remarks last month, Jeremy Powell said  that the Fed’s series of rate increases had brought policy to “just below” the range of estimates of neutral, where it neither spurs nor restricts the economy. 

He also noted that the economy had yet to feel the full impact of the hikes.

Powell’s comments sparked a surge in a stock market that had struggled of late and came in the wake of repeated criticism of the Fed’s rate increases by President Donald Trump.

Policy makers provisionally penciled in three quarter-percentage-point rate increases for next year, according to the median of forecasts released in September’s so-called dot plot.

The S&P 500 Index rose the most since March, while yields on two-year Treasuries fell 2 basis points, as traders dialed back their expectations for interest-rate hikes. 

Next month’s expected quarter-point increase would lift the
central bank’s target for the federal funds rate to a range of
2.25 percent to 2.5 percent. 

That would bring it in line with the current levels of inflation, making the monetary policy truly neutral.

2018’s jump in the US economic rate of growth was primarily driven by the one-off shot in the arm of the Trump tax cuts. 

As we argued many times, delivering tax cuts at the peak of an economic cycle just exacerbates the trends in place and lay down the foundations of the next down urn.

This is exactly what happened in 2018 where the tax cuts boosted spending and investment power in an economy that was already running at the lowest unemployment rate seen in decades.

The net result was a jump in consumption and an increase in wage pressures.  

Logically, the FED had to increase interest rates and normalize monetary policy so as to contain inflation while keeping the momentum going.

And this is exactly where we are at with interest rates matching inflation rates.

But, as always, rising interest rates have a tremendous impact on liquidity, valuations and corporate earnings. 

As a result, 2018 is, for now, one of the very few years where all asset classes delivered negative performances apart from cash.

The key question is whether the world economy has peaked and is falling into the next recession.

Trade wars, falling stock markets and a collapse in corporate bonds have all added uncertainty to the economic outlook.

Trade Wars put Investments on hold

Donald Trump’s crusade against China did a lot of damage to the world economy.  

It slowed economic activity marginally in China and Asia, but created a lot of uncertainty with investments, as CEO’s from all countries no longer have a stable environment to make their investment decisions.

Corporate leaders worry about the next Presidential Tweets instead of focusing on their investment plans, withdrawing a significant source of support for the global economic momentum of the world.

Tariffs applied to US imports of Chinese goods increased prices for US consumers and reduced profit margins for US corporations, while painting a somber picture for their future presence in the largest consumer of the world.

But it also took a toll on global investments and consumption by creating a psychology of war in a world that just started feeling better after the 2008 financial crisis.

One of the best illustration of the phenomenon is Europe.

Europe’s re-structuring needed strong consumption and strong exports, but exports and business confidence were shattered by the Trade Wars.

This is clearly visible in the third quarter unusual weakness in the three most industrialized exporting economies of Europe : Germany, Switzerland and Sweden.

In Germany, the economy shrank in the third quarter for the first time since 2015 as the automobile industry was hit by new emissions testing and an unexpected fall in exports.

Exports from Germany exports declined 1.2 percent year-on-year to EUR 109.1 billion in September 2018, as sales to the EU contracted 0.4 percent to EUR 64.7 billion. But exports to countries outside the EU shrank 2.2 percent to EUR 44.4 billion.

Germany is primarily an industrial machinery and final goods exporter.
The threats of Tariffs on German vehicles in the US and the scaling down of investments in both the US and China had a significant impact on German exports.

And the lack of momentum in German exports had nothing to do with the  EUR which depreciated from 1.25 in April to 1.12 in October, amounting to an 11 % increase in exports competitiveness over the period.

 It simply had to do with a significant decrease in investment demand from the rest of the world.

In Switzerland too, the economy unexpectedly shrank 0.2 percent in the three months to September 2018, after a 0.7 percent growth in the previous period and missing market expectations of a 0.4 percent expansion. 

It was the first quarterly contraction since the fourth quarter of 2016, as net trade contributed negatively to the GDP and investment in equipment slumped. Household consumption was unchanged.  

Swiss exports unexpectedly slumped in the third quarter only to recover in October 2018.

The only explanation for the slump in Swiss exports – they account for 46 % of the GDP, one of the highest in the world save for the Oil producing countries – is the sudden lack of investment demand in the rest of the world

The Swedish economy also contracted unexpectedly by -0.2 % in the 3rd Quarter of 2018. The quarterly contraction is the nation’s first since 2013.  

Although exports overall made a positive contribution, it was services exports that performed well, while goods’ exports decreased unexpectedly. 

Sweden is also a highly industrialized export-oriented economy. 

Its main industries include motor vehicles, telecommunications, pharmaceuticals, industrial machines, precision equipment, chemical goods, home goods and appliances, forestry, iron, and steel. 

Sweden is renowned for its engineering, mining, steel, and pulp industries that are competitive internationally, as evidenced by companies like Ericsson, ASEA/ABB, IKEA, SKF, Alfa Laval, AGA, and Dyno Nobel.

This sudden and global fall in INVESTMENTS  is HIGHLY UNUSUAL in a world where economic growth is on the uptrend, consumption strong, corporate earnings at record highs and interest rates still very low.

The only explanation is a sharp deterioration in business sentiment.

In the USA, the Institute for Supply Management’s Manufacturing PMI in the US fell to 57.7 in October of 2018 from 59.8 in September and below market expectations of 59. 

The reading pointed to the slowest growth in factory activity in six months after reaching the highest since 2004 in August. New orders, production and employment eased and price pressures continued. 

In China, the Official NBS Manufacturing PMI in China fell to 50.2 in October 2018 from 50.8 in the previous month and missing market consensus of 50.6. 

The reading pointed to the weakest pace of expansion in the manufacturing sector since a contraction in July 2016, as output rose the least in eight months (52 vs 53 in September) and new order growth continued to slow (50.8 vs 52), with export sales falling for the fifth straight month (46.9 vs 48).

There again, Business confidence took a sharp turn to the worst following the launch of Donald Trump’s Trade War in February.

In Japan, the threats of tariffs on US imports of Japanese cars had an immediate effect on the auto industry and Business confidence started declining sharply as soon as Trade Wars took center stage.

Currency competitiveness was not the issue as the US dollar strengthened against the Japanese Yen over the same period, something that usually makes Japanese exports rev up.

In Europe, the business climate indicator picked up to 1.09 in November 2018 from a 17-month low of 1.01 in October.  There again, neither consumption, which has been clocking record highs after record highs in 2018, nor the exchange rate could be faulted as the Euro depreciated against the US dollar over the period. But interestingly enough, the fall started in February when the Trade Wars started.

The only valid explanation to the sudden and unusual decline in Business Confidence and the corresponding slowdown in investments and fixed capital formation is the UNCERTAINTY created by Donald Trump’s Trade Wars.

A confirming indicator is the simultaneous decline in exports of goods in all the major economies of the world, at a time where consumption remained strong.

CEOs are holding off and avoid committing to new investment plans.

Even worse, in the US, the recent decision of GM to shut down factories and engage in cost cutting plans illustrates the fact that CEOs are now moving to their “Plan B” :  

Keep profits growing by cutting costs rather than by making new investments.

Stock market Blues

2018 was a bumper year for corporate earnings with annual growth rates north of 20 % in the US, in Japan, in most Emerging markets economies and in the non-financial sector in China.

Even in Europe which is lagging behind in the recovery cycle, earnings growth has been strong thanks to consumption, low interest rates and strong exports until Q2 2018.

As is always the case, higher stock prices and strong real estate markets also contributed to global growth through the “wealth effect” whereby consumers see their asset base grow and feel more confident and willing to consume and borrow.

As could be expected, higher interest rates, higher labor costs and uncertainty about exports ended the valuation expansion phenomenon that propelled global stock markets into the longest period of appreciation in history.

Global equity markets peaked in January 2018 and US equity markets peaked in September 2018.

Even more telling is the end of the technology sector lead, the one sector that was at the core of the entire 2009 – 2018 bull market.

The sharp correction of last October was a stark reminder of what happens when psychology turns at extremes of overvaluations.

But when that happens the Wealth effect goes into reverse and consumers suddenly retract.

In Europe, where stock markets peaked in January, Consumer confidence started collapsing in June.

The consumer confidence indicator in the Euro Area came in at -3.9 in November 2018, sharply below October’s final figure of -2.7. 

It was the weakest reading since March 2017 due to a deterioration of all its components, i.e. consumers’ unemployment and savings expectations and their views on their future financial situation and the future general economic situation. 

In the European Union as a whole, the consumer sentiment index was also confirmed at a 20-month low of -3.7 in November.

The question that begs to be asked is how can that happen when unemployment is at its lowest in a decade and interest rates are at zero.

In China, the correlation is even more striking with Consumer confidence falling sharply as of March after a massive improvement since 2016, just as Donald trump launched his Trade War and the Chinese stock markets started falling.

There again, nothing in the traditional macro-economic metrics of China justified such as fall, as real estate prices kept on going up, monetary policy remained accommodative, consumer credit kept growing and disposable income continued to grow.

In China, the correlation between consumer confidence and the stock market is unusually high as can be seen from the falls in 2009, 2013 and 2016, when the stock market fell in the previous quarters.

In the US, where equities rose until September, it is extremely likely that we will see the same phenomenon taking place in the coming months, unless the stock market stabilizes quickly.

Falling stock markets are bound to have a significant effect on consumption and the global economy in the months to come.

Global uncertainty ended up killing the Corporate Bond Market

In less than a month, the world credit markets went into a tail spin.

We had been warning for years that fixed income bonds and credit markets were mispriced and kept artificially expensive by the abnormal monetary policies pursued by the world’s three largest Central Banks.

In the process, cheap credit led to another binge of consumer and public borrowing and the world’s aggregate stock of debt is now at much higher levels than at anytime in history, including the excesses of 2007.

The World’s total stock of debt reached $230 trillion in the last quarter or 313 % of the World GDP, and, contrary to what some analysts tend to portray, the largest increase does not come from China but actually from the USA.

This 2014 Chart from the US Federal Reserve plots the increase of America’s total stock of debt and how the debt contraction of 2009 – 2010 was just a blip in what is undoubtedly an addiction to debt.

We are now at much higher levels and the growth rate of US debt has gone back into double digit in the past two years.

To put this into perspective the 2008 US meltdown occurred when household debt reached about 120 percent total debt to annual GDP. 

The only way to keep payments current is with a low rate environment. 

The 2018 cracks in equity markets translated into a sharp repricing of risk and BBB corporate debt suddenly breached the 8 % and high yields breached the 12 % thresholds for US dollar denominated debt.

The impact of sharply higher rates on both corporations and individuals will have tremendously negative effects on corporate earnings, investments and consumption, eventually leading to the next recession.

In a nutshell, the unexpected UNCERTAINTIES created by Donald Trump’s Trade wars have dealt a severe blow to the World economy.

They triggered a chain reaction in investments, consumption and asset prices that could have tremendous deflationary consequences

Whatever strategic or political objectives Mr. Trump had in launching his Trade Wars, he may have unleashed a highly destructive dynamic for the world economy.

Only a QUICK RESOLUTION OF THE TRADE WARS will restore global confidence.


… and the US economy probably more than any other considering its high leverage and extreme reliance on a highly indebted consumer.