Risks Facing Equities In 2018

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by: Ivan Martchev

The noose seems to be tightening in the Mueller investigation with a guilty plea by former national security adviser Michael Flynn, which is only good if it leads to the successful prosecution of other targets in the probe (that was spelled out verbatim in the plea deal).

The market did not take that well on Friday, although there was a substantial recovery in all indexes by the end of the day on news that the GOP had enough votes to pass the tax reform bill in the Senate.

The issue is that many of the GOP senators that voted for the bill are unlikely to have carefully read the whole legislation, which runs over 400 pages long. Also, due to the numerous last-minute handwritten changes - the major reason voting extended into the early hours of Saturday - many Senators are unlikely to have considered all the pros and cons of the bill.

As the Wall Street Journal summarized the bill:

The bill, which included about $1.4 trillion in tax cuts, would lower the corporate rate to 20% from 35%, reshape international business tax rules and temporarily lower individual taxes. It also touched other Republican goals, including opening the Arctic National Wildlife Refuge to oil drilling and repealing the mandate that individuals purchase health insurance, which would punch a sizable hole in the 2010 Affordable Care Act. But some objectives, such as repealing the alternative minimum tax, fell by the wayside in last-minute wrangling.

The bill still needs to be reconciled with the House version before we can make any conclusions as to how it will affect the economy. While on the surface tax reform looks positive for 2018, I do think that we have several wild cards next year that are difficult to quantify and could go either way.

Here are four wild cards that I think have the potential to rock the markets next year.

Four Wild Cards for 2018

First, the Mueller investigation seems to be gathering momentum. We don't know how high it will ultimately reach, but suffice to say it is right now reaching ever higher. It looks like there will be more shoes to drop, so a political scandal similar to the impeachment of President Bill Clinton cannot be ruled out. The issue with Clinton is that he was impeached and tried in the Senate, but ultimately acquitted. This is why the Alabama Senatorial election on December 12 is so important to the White House and explains how President Trump would back the highly-questionable GOP candidate Roy Moore, even though the Senate Majority leader has considered expelling him from the Senate should he win.

Second, we have Kim Jong Un testing ever more powerful ICBMs. This situation seems to be going towards a military confrontation, should Kim's tests follow their accelerating frequency in 2018. If it does end up in a military confrontation, I think that Kim will lose badly, but before he does we are likely headed towards a sharp sell-off in global markets similar to what we saw in August-September 1998 that marked the end of the Asian Crisis and the Russian sovereign bond default. Kim is likely to retaliate as Seoul is within his artillery firing range.

United States Central Bank Balance Sheet Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Third, the top three people at the Federal Reserve are leaving, more or less at the same time. Janet Yellen's term ends in early February 2018 and the person taking over, Jerome Powell, is a very accomplished lawyer and a financial services industry executive but that also means he has no Ph.D. in economics. The Vice Chairman of the Federal Reserve Stanley Fischer resigned in September 2017 for personal reasons, in my opinion because it became clear he was out of consideration for the position of Chairman. This is probably the same reason why the CEO of the Federal Reserve Bank of New York, Bill Dudley, is retiring in 2018. With the top three people at the Fed leaving, who is going to unwind the Federal Reserve balance sheet, which at last count stands at $4.42 trillion? Somehow Jerome Powell's financial services industry experience and legal expertise do not reassure me as much as the resumes of the top three leaders leaving the Fed.

United States Ten Year Government Bond Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Unwinding the Fed's balance sheet can create a long-term interest spike that becomes a problem for the economy. Right now, the monthly runoff rate for bonds maturing from the Fed's balance sheet (and not getting reinvested) is $10 billion. What is going to happen to the 10-year Treasury yield if that runoff rate rises to $50 billion in 2018? I would feel a lot better if Stanley Fischer (Ben Bernanke's graduate thesis coordinator at MIT) or Bill Dudley (Goldman Sachs (GS) former Chief U.S. Economist) oversaw that process.

Chinese Yuan versus China Foreign Exchange Reserves Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The last wild card is China, which managed to stabilize the outflows of foreign exchange reserves in 2017, after losing $1 trillion in two years. I think that the Chinese economy is over the hill of an epic credit bubble that took the total leverage in the economy from 100% at the turn of the century to 400% at present, if one counts the infamous shadow banking leverage. As the Chinese economy grew 12-fold in that period, total debt in the economy grew more than 40-fold.

What we are witnessing in China today is similar to a credit bubble that led to a period of fast economic growth in the U.S. called The Roaring Twenties, which ended with The Great Depression. I am not necessarily advocating for a Chinese Great Depression because in the case of the United States there were some very serious monetary and fiscal policy mistakes that turned a recession into a depression.

Still, I have no doubt that the Chinese are headed for a hard landing given their spectacular credit bubble, which I think will have a similar outcome to the Asian Crisis in 1997-1998 with the caveat that the Chinese economy today is much bigger than the total GDP of all countries involved in the Asian Crisis.

Given the wild cards facing equity investors, 2018 promises to be more eventful than 2017.

Disclosure: *Navellier may hold securities in one or more investment strategies offered to its clients.

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