Do Not Blame China For U.S. Dependence On Debt, Deficits, And Low Rates

Summary

• Many in the financial media describe the current corrective activity in stocks as a function of the possibility of a "trade war" with China.
• In truth, tariffs and trade disputes are a bit of a sideshow.
• The real danger in poking the panda is China's ability to severely slow down its purchases of U.S. Treasury bonds.
• If China, the largest holder of U.S. Treasuries, does not buy enough U.S. government sovereign debt, other buyers would need to step in. They’d do so, but that would occur at higher interest rates.
• Higher borrowing costs will hurt consumers and companies alike, hampering the economy as well as stock buyback plans and stock prices.

Over the 10 trading days (two weeks) through April 6, the S&P 500 averaged a daily range of 2.3%. According to Dana Lyons of the Lyons Share, that kind of volatility ranks in the 94th percentile since the S&P 500 began in 1950.

Similarly, it is uncommon to see at least seven 1%-plus price swings in a brief period like two weeks. We actually had eight. More remarkably, it is rare to witness this type of price movement when it is confined to a total range of 5% or less. How unusual? Less than 1/10 of one percent of trading sessions in the S&P 500's history.

In the chart above, it appears that the occasions (14 in total) may have acted as a warning sign. For example, in 2001, big price swings accompanied by range-bound markets (< 5%) preceded the painful bearish depreciation of 2002. More ominous? The same thing happened leading into 2008's financial crisis. In 2004, however, it was "much ado about nothing."

Here in 2018, the volatility alongside range-bound stocks may indeed be relevant. Why? Volatility is inversely related to financial system liquidity. It follows that as long as the Federal Reserve (and other prominent central banks) remains committed to removing liquidity by reducing bloated balance sheets, one can expect the volatility to increase.

In the same vein, committee members at the Federal Reserve appear determined to hike shorter-term interest rates. Yet longer-term rates have not responded as much as central bank planners would like. Consequently, we are looking at the flattest yield curve since 2007.

On the surface, there may not be a problem with 10-year Treasury bond yields mimicking two-year Treasury bond yields. Or 30-year Treasury bond yields resembling five-year Treasury bond yields.

On the other hand, neither the U.S. stock market nor the U.S. economy has ever performed particularly well when longer-term yields fall below shorter-term ones. The phenomenon is called "yield curve inversion," and it is often associated with economic recession. Indeed, should the Fed remain resolute, the 40 basis point differential between the 30-year and the five-year might evaporate quickly and subsequently invert.

Why are the mainstream media downplaying yield curve concerns? Many prefer to describe the current corrective activity in stocks as a function of the possibility of a "trade war" with China.

Truthfully, though, tariffs and trade disputes are a bit of a sideshow. The real danger in poking the panda is China's ability to severely slow down its purchases of U.S. Treasury bonds.

Remember, the U.S. government regularly spends hundreds of billions, even trillions, up and above the revenue it takes in. It is called "deficit spending." And it requires that we issue more and more debt to finance the difference. (Note: We recently pierced the $21 trillion level.)

So if China, the largest holder of U.S. Treasuries, does not buy enough U.S. government sovereign debt, other buyers would need to step in. They'd do so, but that would occur at higher interest rates. And those rates might move higher rather quickly.

Granted, if this were to occur, we might not be looking at an inverted yield curve with rising five-year and 10-year Treasury bond yields. Yet we'd certainly be talking about an economic slowdown and/or a stock market bear. Real estate "refis" and affordability are already being stretched with mortgage rates where they are right now.

So far, the investment community is maintaining its composure. Most anticipate robust earnings-per-share growth due to the tax cut stimulus. Others believe that the president would be wary of rocking the stock boat by going too hard at China.

On the flip side, fewer and fewer S&P 500 stocks currently boast technical uptrends. Bullish percentage has not been this weak since Q1 of 2016.

In January/February of 2016, though, the global economy received a collective quantitative easing/liquidity bailout from both the European Central Bank (ECB) as well as the Bank of Japan (BOJ). Meanwhile, the Federal Reserve went from signaling four rate hikes in 2016 to pacifying markets with a single rate hike in mid-December.

In the current environment, there are no liquidity injections intended to bolster and protect stocks at current levels. On the contrary, investors in risk assets may have to live without volatility-suppressing liquidity from central banks.

At the moment, cash and cash equivalents are outperforming stocks and bonds. How often is cash king? According to Charlie Bilello of Pension Partners, cash is only king about 1/8th of the time on a calendar year basis. It is not a great investment decision for longer-term periods like a decade or 20-plus years.

Nevertheless, cash equivalents like Guggenheim Ultra Short Duration (NYSEARCA:GSY) and PIMCO Enhanced Short Maturity Active (NYSEARCA:MINT) have 30-day SEC yields around 1.9%. It may be prudent for soon-to-be retirees and retirees to balance some of the near-term issues with stocks and riskier bond funds (e.g., intermediate, long, high-yield/low credit quality, etc.) with ultra-short duration bonds (a.k.a. "cash equivalents.").

Would this be beneficial over longer periods? Probably not. Yet for those folks who may not be comfortable will erratic price swings in their portfolios, ETFs like Guggenheim Ultra Short Duration and PIMCO Enhanced Short Maturity Active are worthy contenders. What's more, when a bear market eventually mauls stocks, one would have the cash on hand to buy quality names at bargain prices.

Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell, or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationships.