Last week, as US equity markets were making new all-time highs and emerging markets were rebounding we flashed an orange warning signal.
The weak internal dynamics of US equities, the unusual rise in bonds yields and equity markets at the same time, the loss of leadership of the tech sector and hyper speculative nature of the markets were all elements that triggered warning bells for us.
Today’s Italian budget and sharp fall in European markets – that we cautioned about – are bringing a new element of risk in a macro-economic landscape that investors seem to be ignoring for too long.
In our various articles since the beginning of the year, we warned about the return of inflation and the tightening of liquidity that would necessarily ensue, we predicted the subsequent rise in the US dollar – against the consensus view – and predicted the end of the Technology sector leadership.
This week, the FED raised rates for the third time this year and Jerome Powell’s carefully crafted message is that the US monetary authority would keep on rising rates as long as growth and inflation remained strong.
US GDP exploded upwards from 2.2 % in Q1 2018 to 4.2 % in Q2 2018 and most indicators are pointing to another bumper quarter at 4.2 or 4.3 % in Q3 2018 as Donald Trump’s Tax cuts are boosting the US economy.
Unemployment is at multi-decades low and wages are starting to rise sequentially as a result, as we anticipated.
Donald Trump’s Trade wars are starting to bite – not China but the US – by increasing the cost or the price of goods sold in the US, and high flying oils prices are also contributing to higher inflation ahead.
Bond yields have broken the 3 % level decisively, a 50 % increase in financial costs and budgetary burden in a little are than a year and global investors are still chasing levitating stocks higher while the bulk of the market is not following suit.
From an economic standpoint, Donald Trump’s fiscal reforms are an aberration at this stage of the cycle.
Never in the history of the USA, or even of any major economy, an administration has injected a supply-side shot in the arm in an economy that was already on a strong recovery path way before the presidential elections following eight years of extra-ordinarily stimulative monetary policies since the 2008 financial crisis.
In normal economic management, supply-side stimulus is used at economic through to stimulate the recovery and avoided in strong economic environments to restore public finances health.
This time round, at the peak of the cycle, Donald Trump has reduced Tax receipts in the hope that incremental growth would trigger more tax receipts and fill the gap.
But in taking that blunt risk, he has left the US public finances in a fragile position, with a shortfall of US$ 1.5 Trillion – in a country that already has a need for at least US$ 1.5 Trillion of investments to restore a derelict infrastructure – leaving the Fed and Congress with very little ammunition for when the next downturn takes place.
Being the dominant economic and geo-political power of the world, the US has benefitted from the willingness of the rest of the world to use the US dollar as its reserve currency and to consider US Treasuries as the ultimate credit risk.
As Thomas Friedman put it recently in a great article in the New York Times, it is amazing how America exported a major financial crisis to the rest of the world in 2008 because of its own debt excesses and how for the past ten years the whole world has been willing to pour money back into the US and US Bonds.
When global investors start facing a US downturn and a deteriorating US fiscal position, the rout in US bonds and the US dollar will be dramatic.
And this where Donald Trump’s Trade War with China comes at exactly the wrong time ….
Contrary to the US, China enjoys a strong public finances position, a thriving consumer market that is the world’s main driver of growth and a significant advantage in terms of infrastructure efficiency. It boast 25 % of GDP as Foreign exchange reserves, is the largest holder of US Treasuries and it both the largest manufacturing base of American companies AND the largest market for their products in the long term.
As Ford Motor Co. Chief Executive Officer Jim Hackett put it recently, the ill-conceived trade war with China has already cost Ford Motor Co US$ 1 billion in profits already and is creating an atmosphere of uncertainty that is preventing US corporations to plan for the future and invest.
This week’s address of Donald Trump to the UN General Assembly was greeted with laughters and strong criticism by even the most solid allied of the Usa on the geo-political scene, testifying of the increasing isolation of Donald Trump in his Trade War crusade.
By keeping ultra accommodative monetary policies even until now – Rates at 2.25 % and inflation at 2.70 % i.e. still negative real rates – and providing a one-off tax effect on corporate profits and individuals purchasing power, America has sent the most expensive equity markets in history to even higher levels in an asset bubble characterized by extremely high concentration in one very limited segment of the the US economy, technology.
In the latest release of economic data, US consumption is starting to peak and confidence is starting to wane.
The litmus test for the US equity market will ultimately be the third quarter corporate earnings.
Wall Street expects another bumper + 22 to 24 % increase in profits year-on year, but more and more analysts are voting their concerns about the sustainability of these earnings growth rates.
Any disappointing figures will make investors seriously question the validity of the current elevated valuations of US equities in the face of more muted earnings growth.
Finally, te most worrying factor as far as equities are concerned is the extreme level of bullishness of investors.
The chart below pit by the excellent technical team of Michael Riesner of GMCP says it all.
The ISEE sentiment index has hit a new all‐time high last week, together with an extremely unusual cluster of Hindenburg signals.
The ISEE index measures the call/put ratio of retail investors and excludes the market action of market makers, so this is a very good and clean indicator of measuring the “real” speculative positioning of investors.
The current overshooting of the ISEE Index is a pure contrarian signal together with the Investor Intelligence Bullish Consensus hitting the 60% threshold.
All the conditions are in place for a severe and sharp correction in the weeks to come..
Let us be clear, we do not see this as more than a sharp correction that will provide a great opportunity to invest before a strong year-end rally that may sustain itself into the first quarter of 2019.
We do not see the world economy falling off a cliff and there are no major systemic financial risks on the horizon for now.
But we see a strong underperformance of US equities in the coming six months while China and Asia stand to be the main beneficiaries ahead.
The correction will provide an excellent entry point into European equities as well.
In the mean time, the month of October could prove to be very volatile…