'What Are We Gonna Do Now?'

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Includes: AA, CNY, CYB, DIA, SPY, UUP
by: The Heisenberg
Summary

In light of recent events, it's important to take a step back and assess how the Fed's decision calculus might have changed over the past 72 hours.

Importantly, there was a built-in circuit-breaker for risk assets when it comes to Fed hikes, the stronger dollar and the effect on emerging market currencies and other developing economy assets.

Now, Jerome Powell might be more reluctant to take a hammer to the "break glass in case of emergency" box.

Here's an in-depth look at the situation complete with a list of Powell's options and simulations for the yuan and U.S. financial conditions.

One of the ideas I've tried to drive home (somewhat desperately and to varying degrees of success) with my recent posts for this platform is that U.S. equities (SPY) likely can't ignore what's going on in the rest of the world forever. And when I say that, I'm not just tossing out a nebulous statement about the interconnected nature of modern markets.

The fact that recent stumbles in developing economy assets, the rapid weakening of the Chinese yuan, and plunging commodity prices (just to throw a few examples out there) are all to a greater or lesser degree the product of U.S. economic policy means there's something paradoxical about investors pretending the current juxtaposition between U.S. stocks and everything else is sustainable.

It's true that U.S. fiscal policy has fostered domestic conditions that are conducive to a short-term sugar high for corporate earnings. It's also true that the tax cuts have emboldened corporate management teams to buy back shares a record clip (although the veracity of the "record" characterization depends on how you break things down), thus further supporting U.S. stocks. I've said repeatedly that as long as those pillars (robust earnings growth and buybacks) are firmly in place, it's possible that the cognitive dissonance inherent in record (or near-record) highs on U.S. benchmarks won't be exposed for the folly that it most likely is. Or at least it won't be exposed in the near-term.

But - and here's where I will make a nebulous statement about interconnected markets - the spillover risk is high. I'm particularly fond of the following quote from "America First":

It's the U.S. versus the rest of the world at this juncture when it comes to markets and what I would encourage investors to keep in mind is the fact that markets are more interconnected than they've ever been. That interconnectedness is mirrored in global supply chains and all other aspects of global trade and commerce.

At this point, you're undoubtedly aware that the trade tensions have started to manifest themselves in nervous communications emanating from corporate management teams, even if outright guidance cuts have been relatively rare thus far. General Motors (GM) and Harley-Davidson (HOG) are good examples (here and here) of companies that have warned about the possible impact of the tariffs on U.S. investment spending and jobs. Meanwhile, Alcoa (AA) cut guidance this week, citing the impact of the trade restrictions. Foreign companies like BMW (OTCPK:BMWYY) and Daimler (OTCPK:DDAIF) have also indicated that the outlook has been muddied materially.

Meanwhile, U.S. farmers are feeling exceptionally nervous as prices for their crops fall. The Bloomberg agriculture subindex hit all-time lows this month amid a broader decline across commodities.

(Bloomberg)

As far as mentions of trade in Q2 earnings reports are concerned, there's obviously a long way to go, but on Monday, BofAML's Savita Subramanian noted that it's a "so far, so good" type of situation. To wit:

Few companies have issued guidance in July, but trends as of now indicate optimism – management has continued to guide above analysts’ raised expectations. Of the Banks that reported last week, responses to questions on tariffs/trade indicated no significant changes in consumer behaviour or impacts to businesses so far. Given that a trade war — and its potential impact to global growth — is a risk to the global S&P 500, we are monitoring guidance/commentary closely for any signs of deteriorating outlooks.

As indicated, there are clear transmission channels to U.S. corporate bottom lines as some of the companies mentioned above have tried to make clear. On Friday, in an effort to spell things out for investors, Goldman wrote that "tariffs pose a risk to S&P 500 earnings through two channels: lower revenues from exports and higher input costs and weaker margins."

Specifically, the bank said this about the latter point:

Imports from China comprise 18% of total US imports. Conservatively assuming no substitution to other suppliers or pass-through of costs, and no boost to domestic revenues or change in economic activity, a 10% tariff on all imports from China would lower our 2019 S&P 500 EPS estimate by 3% to $165. If tensions spread and a 10% tariff were implemented on all US imports (highest rate since 1940s) our EPS estimate would fall by 15% to $145.

Recent comments from Jerome Powell (notably, in Sintra) and the June Fed minutes suggest the FOMC is starting to hear rumblings. Here's the quote that matters on this issue from the minutes:

Many District contacts expressed concern about the possible adverse effects of tariffs and other proposed trade restrictions, both domestically and abroad, on future investment activity; contacts in some Districts indicated that plans for capital spending had been scaled back or postponed as a result of uncertainty over trade policy.

And I could go on. The point is that this is starting to bite on the home front, and the more it escalates, the more painful that bite is likely to get.

But more broadly (i.e., stepping back a bit from the specific corporate communications and from the numbers), the idea that risk sentiment stateside won't eventually suffer as emerging markets continue to struggle and as ongoing weakness in the yuan rekindles not-so-fond memories of 2015, flies in the face of common sense. Sometimes, U.S.-focused investors (especially of the retail variety) have a penchant for suggesting that nothing matters outside of the S&P, the Dow and the Nasdaq. Here are a couple of great excerpts that touch on this point from a Thursday missive penned by former trader turned Bloomberg columnist Richard Breslow:

There was one line of questioning at yesterday’s Congressional hearing [for Powell] that I did find disingenuous in both the asking and answering. It went along the lines of whether the Fed was meant to be focused solely on America to the exclusion of the rest of the world. That actually is no longer a realistic assumption. But be that as it may, the rest of the world can’t implode, or thrive, without it being directly felt domestically, even if, perhaps, not immediately.

China, commodity prices or emerging markets aren’t theoretical concepts.

I love that last bit. The yuan is a real thing. So are emerging market bonds and equities. And so are commodity prices. They don't cease to exist just because you prefer to watch the FAANG basket and they don't become less real just because late-cycle fiscal stimulus has helped U.S. stocks recoup losses after intermittent bouts of turmoil this year.

Ok, here's where this gets interesting. I've been over this on this platform (and on my site) on more occasions lately than I care to count, but I'm going to rehash it quickly here because it's necessary to make the point I want to make.

The reason the Fed has to be so hawkish in the first place is because the Trump administration's fiscal policies amount to piling stimulus atop a late-cycle dynamic, increasing the risk of inflation. Tariffs exacerbate this situation because protectionism, in the early stages, is inflationary; that is, it has the potential to drive up domestic prices.

Thus, the policy divergence between the Fed and the rest of the world is in part a byproduct of the same late-cycle stimulus that's helping to juice the U.S. economy and U.S. stocks. That policy divergence is what's driving the dollar (UUP) higher and, in turn, putting depreciation pressure on the yuan and facilitating weakness in other emerging market currencies and also developing nation stocks and bonds. For the full treatment on this subject, please see here (I spent a ton of time on that linked article and I genuinely think it does a nice job of framing this week's events).

Prior to Thursday, there was a built-in fail-safe (a circuit-breaker, as it were) for risk assets, including the carry trade in all its various manifestations. Here's a great flow chart from Deutsche Bank along with the accompanying color that tells you how to read it:

We start at the lower left corner. Fed hikes and strong USD open up the EM dilemma: Facing the outflows or defending the currency at expense of stifling the growth. This implies both more volatility and potential sell off in EM, and bearish pressure on the long end of the UST that would offset the underlying bid for US bonds (strong USD is bullish). Turbulence in EM could have a knock-on effect on risk assets in the US. An example is the 2015 episode where asset managers faced redemptions due to EM losses and had to sell the best performing assets (US equities) to cover those costs. This means more turbulence in developed markets and possible tightening of financial conditions, which could possibly push Fed to take a pause.

The bit in bold is the circuit-breaker. Too much EM spillover from hawkish U.S. monetary policy could eventually feed back into developed market assets, tightening financial conditions and forcing the Fed to back off.

Well, that's been called into question. Now that the President has explicitly said he is "not thrilled" with rate hikes and now that he's explicitly indicated that he is aware of the extent to which those hikes are effectively watering down the effect of the tariffs on America's trade partners, it opens the Fed up to criticism in the event Jerome Powell does feel compelled by market forces to take a break from hiking.

As I put it on Friday, now Powell either has to keep hiking or risk being accused by some market participants (not to mention lawmakers) of bowing to political pressure from the White House. That's not just my assessment. It's the assessment of just about everyone you care to ask who has any claim to an informed opinion. Consider these excerpts from a Bloomberg article dated Friday, for instance:

“This is such a risky thing for the Fed, and for the president, and for central bank independence,” said Peter Conti-Brown, a Fed historian at the University of Pennsylvania’s Wharton School.

Now, even if the Fed pauses its rate-hike campaign for valid economic reasons, it could look politicized. There will be many “who see that as the Fed yielding to a combative president,” Conti-Brown said.

In other words, the glass on the "break glass in case of emergency" box may now be a lot harder to break or, put differently, Jerome Powell might be more reluctant to break it.

I'm fond of employing American cinema references in my writing and because I haven't trotted one out in a while, I thought I would use one here. This reminds me a lot of the moment in James Cameron's immortal classic Aliens, when a distraught Hudson (Bill Paxton), after sorting through the wreckage of a ship that was supposed to rescue the protagonists from a hostile planet, looks around at his compatriots and exclaims:

Well that's great, that's just great man. Now what are we supposed to do? What are we gonna do now? What are we gonna do?

I assume nearly all readers in the United States will be familiar with that reference.

This problem will become more vexing the more yuan weakness China is willing to stomach. The more the yuan falls, the more pressure there will be on Jerome Powell, one way or another. In all likelihood, further RMB weakness will spillover into emerging markets more generally and could exacerbate the commodities selloff. Past a certain point, that will start to manifest itself in jittery developed market assets, including U.S. stocks (if you don't believe me, just go back and look at what happened during August 2015, the closest historical analog). For those interested in some specifics, here they are from a Deutsche Bank noted dated Thursday:

We can analyze the impact of RMB devaluation in terms of financial conditions and the impact on the Fed stance. As was the case in 2015 and has held true of late, a quickly depreciating CNY would not happen in a vacuum – it would inevitably be accompanied by similar scale weakness in other EM Asia FX – as was the case in 2015 and has been the case for the bulk of this year. Ultimately, it implies that the Fed would be justified in a softer stance than otherwise.

In the above table, we illustrate the impact on financial conditions from dollar strength implied by different USDCNY levels and rates of deceleration. For the sake of our estimates, we assume similar scale depreciation across Asia EM currencies when calculating the impact to the trade weighted dollar. A lower value of FCI is consistent with tighter conditions, which are scaled to mean zero and standard deviation of one – a move to USDCNY of 8 in 3 months’ time would imply more than half a standard deviation tightening in US financial conditions. Historically, tighter financial conditions in the US have been well correlated with weakness in EM equities, shown in the chart on the right.

As Deutsche Bank notes there, the concurrent tightening of U.S. financial conditions would likely argue for a Fed pause, but again, Jerome Powell might be reluctant to go that route given the political overtones.

If, by some miracle, the RMB depreciates without causing much in the way of contagion, the Fed will still be under pressure to adopt a more dovish stance because the steeper the selloff in the yuan, the less effective the U.S. tariffs are on China. Here's a bit of technical color on Beijing's decision calculus excerpted from the same Deutsche Bank note:

The choice for China is whether it is better to maintain market share via RMB devaluation or RMB price cuts that absorb the tariff or to let the US consumer pay the tariff and have less export growth. The RMB trade surplus might be more stable or even improve if the RMB devalues but it will buy that much fewer reserves. A stable currency may mean a much narrower surplus even though it can buy cheaper dollars. The differences for overall reserve loss and the real growth impact will ultimately depend on US consumer demand elasticity as well as alternative markets for Chinese goods. In our view, the bigger risk for financial markets is an accelerated Chinese devaluation that emphasizes at least a short run desire to maintain export volumes and the RMB surplus albeit at the expense of reserve accumulation. To the extent there are additional tariffs on imports into China, the RMB surplus might improve and insulate reserve accumulation.

If you're starting to get the feeling that China might have a lot more flexibility in terms of how to fight this "war" than the U.S. does, you're not alone.

In case it isn't clear enough from the above, Powell is now painted into a corner. Here are his options:

  1. He can stick to the near-term rate path in keeping with the strength in the U.S. economy and out of respect for the possibility that late-cycle stimulus and tariffs might drive up domestic inflation. But if he does that, he'll likely come under fire for maintaining the policy divergence that's driving the dollar higher and effectively giving America's trade partners a reprieve from the tariffs.
  2. He can stop hiking altogether in order to at least ensure the policy divergence between the U.S. and the rest of the world isn't widening because of his actions (thereby putting the burden squarely on the PBoC when it comes to increasing the gap between U.S. and Chinese monetary policy). But the optics around that are bad in light of the Trump interview and subsequent tweets.
  3. He can try to strike a middle ground by influencing the dot plot (in order to, for instance, align it with what sources say the White House would be comfortable with) and perhaps pair a downshift in the dots with more cautious language in subsequent statements.
  4. He can take a modified approach to the first option, by not only sticking to the script, but by in fact reiterating the resilience of the U.S. economy and leaning even more hawkish in the hope that eventually, he'll invert the curve or cause an outright emerging market meltdown, which would give him enough plausible deniability to pause or even cut rates without risking accusations of playing politics.

That last option might seem absurd (because it effectively entails the Fed chair knowingly courting economic disaster in order to give himself enough political cover to lean dovish), and no, it is certainly not likely to be adopted as "the plan". But hilariously, there's a sense in which it's the only "good" option.

As I'm sure you've noticed, this debate is now the talk of the financial universe and I'm doing my absolute best to keep readers here apprised of the nuances.

The point here isn't so much to suggest that there's absolutely no way out of this situation as much as it is to highlight the quandary the Fed is now facing. This situation is immeasurably more complicated than it was just days ago and it is entirely possible that China knows it.

If you go back up and look at that table from Deutsche Bank, what those figures suggest is that the PBoC, at its discretion (and assuming Beijing is willing to risk capital flight) can effectively force Jerome Powell to make a choice between allowing China to dictate U.S. financial conditions or cutting rates to avoid that outcome at the risk of being accused of not only politicizing monetary policy, but of actively participating in the trade conflict.

Again:

Well that's great, that's just great man. Now what are we supposed to do?

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.