Goldilocks, The Big Bad Bear Is Back

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by: Mark J. Grant

She ate the porridge, sat in the chair, slept in the bed and the bear, along with all of his family, showed up to settle the score. You recall the childhood tale, I am sure. All of last year Goldilocks played away, and each downdraft was marked with a stronger updraft. Ah, 2017, we all loved you. This year, not so much.

The equity markets have gone from placid to volatile and "risk-on" is no longer the winning bet. The "Great Game" has a way of doing this to you, again and again, and you must now go round the corner and utilize different strategies because the old ones will no longer work. The page has turned. Make sure you read the words in this chapter. The words found in the last chapter will no longer suffice.

One part of the "change in attitudes, change in latitudes," is the pull and push between America and China. We are now firmly entrenched in a Trade War. Make no mistake about it. Do not minimize it. The battle has begun.

"But if China's interests are undermined and China's interests are under threat the country will take all necessary measures to defend their interests…This has been the drumbeat China has been striking since this trade war started brewing. If you want to fight we'll be there with you, if you want to talk our door is open. China does not want a trade war." - China's Vice-Commerce Minister Wang

Each day, the equity markets react one way or another. Is it a skirmish or a war? A skirmish, I remind you all, is the first and initial contact. Then, blood begins to flow and egos and saving face come into play and the situation only worsens. That is what I have witnessed in my four decades here, and I expect nothing different this time.

Things will eventually get rectified, in one fashion or the other, but, in the meantime, we are in for some rough sailing. Find the hatches and batten them down because that is exactly what you need to do now. Anyone that tells you to "stay the course" is living in denial. The course has been changed by the winds of economic protectionism, and if you don't make the turn, then you will get run over. That is my opinion.

What we have is the world's two largest economies battling it out for position. China, in my view, for the past several years, has done everything in its power to overcome the United States and be the leading nation of the world. They are hamstrung, however, because they are a one party nation, and they have absolute control over their financial markets, and so their ambitions are curtailed by the manner in which they do business. It will be never, or decades, before this changes and so they can compete, but they cannot overcome, in my estimation, until they change their form of controlled governance.

Still, they can buy the ports, demand the code, leverage their influence but they are limited by their own particular brand of internal politics. It is not a question of right or wrong. It is just a question of what they are trying to accomplish and then the way the rest of the world reacts to it. This is the table at which we are seated, and dim sung is now being served. We are in a "hope for the best but prepare for the worst" moment.

One forthcoming surprise, I think, is going to be the reaction of the central banks. The Fed is going to change its tune about rate hikes. The European Central Bank will not stop its program come September. The Japanese Central Bank will continue on and the PBOC will ramp it up. It will not just be investors that have to do an about face. The world's central banks will also make a turn as demanded by the fighting in the financial trenches.

The Fed will have no choice, really, because economic conditions will worsen because of the trade wars. Make no mistake here, "worse" is coming and it is just a matter of what everyone will do about it. The battle lines have been drawn and now the "forces of reckoning" are about to collide.

What may well win, during the foray, are bonds. I would not be surprised to see the 10 year Treasury head back down in yield, up in price, to the 2.25% to 2.50% range with a continuing flattening of the Yield Curve and risk assets re-pricing wider against Treasuries. If the war is prolonged, it could even be more pronounced with 2.00% to 2.25% being the range as equities find themselves under increasing downward pressure.

The most prominent trade war was ignited by the Smoot-Hawley Tariff Act of 1930. This Act imposed steep tariffs on roughly 20,000 imported goods. America's main trading partners, at that time, retaliated with tariffs on United States exports, which plunged 61% from 1929 to 1933. The tariffs were repealed in 1934.

Other, bigger forces, also came into play. Chief among these was the fall in American GDP, partially caused by the tariff wars of that time. The other was deflation, which was amplified by the effects of the tariff battles caused by the Smoot-Hawley increases. I do not think this Administration will allow the battle to reach that fevered of a pitch, but I am concerned just how far President Trump, and his "Art of the Deal" might push things. One can only hope for the usual foray, then the step-backs that occurred, as predicted, as exemplified by when President Trump first announced his aluminum and steel tariffs.

In the meantime, I suggest that you hunker down. Grant's Rules 1-10, "Preservation of Capital," are back in vogue now. Get out of the way before there is no way out. That is my advice.