Global markets: Five issues to watch

From the crisis in Turkey to upcoming remarks by the U.S. Federal Reserve (Fed) Chair, there is no shortage of issues for investors to watch this week. Below, I highlight five key areas that markets will be monitoring.

1. Will Turkey’s woes spread across emerging markets?

The crisis in Turkey continued last week. Last Wednesday, Qatar pledged US$15 billion in investments for Turkey, which boosted the lira temporarily – even though Turkey needs far more in the way of investment than what has been promised by Qatar. On Thursday, a senior finance official in the Turkish government tried to reassure markets that Turkey would not impose capital controls and that it would do what is necessary to remedy the crisis. But the lira sank again as Standard & Poor’s and Moody’s downgraded its credit rating. In addition, the crisis is becoming more complicated as Turkey is attempting to tie the release of the detained American pastor to major fines that the U.S. wants to impose on a Turkish bank for involvement with Iran. I believe it is unlikely this crisis will end soon, given the Turkish government’s unwillingness to take the measures necessary to resolve it.

And there’s always the risk of “copycat panics” in other emerging-markets countries. I continue to believe there is little chance of direct spillover from Turkey, given the unique issues facing the country. However, as is often the case with a crisis in one emerging-markets country, some or all emerging-markets countries are treated the same way by investors. Some economists and strategists are particularly worried about the potential for contagion spreading to other emerging markets, such as Indonesia and South Africa, which were two of the Fragile Five during the 2013 Taper Tantrum. It is true that sovereign credit ratings of some emerging-markets countries have dropped sharply in the past year and a half, with more now rated below investment grade, so we will need to follow emerging-markets debt closely. That is particularly so given the changed role of the U.S. in emerging markets from calming force to disruptor – that includes the liquidity squeeze being created by the Fed. However, it is important to stress that not all emerging markets can be painted with the same brush; this is a time for investors to understand the fundamentals on a country-by-country basis.

2. Low expectations for U.S.-China trade talks

Helping buoy stocks last week was news of a new round of U.S.-China trade talks later this month. However, I have very low expectations for the meeting and believe we will see something of a repeat of previous U.S.-China trade talks this year, where the stock market reacted positively to news of the talks, only to see them go nowhere.

It appears that these talks will focus on how China can prevent the devaluation of the yuan. In my view, this is unlikely to be a fruitful pursuit given that market forces, including the U.S.’ aggressive stance on tariffs as well as the modestly decelerating Chinese economy, have most likely caused this year’s devaluation of the yuan. So, while I expect China to defend its currency if it trades through the key psychological level of seven yuan per one U.S. dollar, I don’t expect the Chinese to do much more.

Quite frankly, I don’t expect China to make many concessions in any trade talks with the U.S. for a few reasons:

• First of all, South Korea is a cautionary tale of a country that attempted to avoid U.S.-tariff retaliation by voluntarily agreeing to quotas – only to find a very inflexible and onerous set of requirements that has curtailed steel exports from South Korea to the U.S. The U.S. simply did not reward South Korea for playing nice in the sandbox, so there is no incentive for other countries to do the same
• In addition, I would argue that, contrary to conventional wisdom, China holds the upper hand in a trade dispute with the U.S. Its currency is decelerating, helping to compensate for the tariffs imposed on it by the U.S. Moreover, it has the ability to spend in order to compensate for any reduction in growth caused by the tariffs

On the topic of trade deficits, which appears to be an important area of focus for the Trump administration, I believe it is unlikely that China will agree to reduce its trade surplus with the U.S. In my view, this is a somewhat nonsensical demand by the U.S. given that trade surpluses are a function of market forces – something that is normal and to be expected of a wealthy, consumption-based economy. The U.S. has routinely run trade deficits with other countries since the 1980s, which should be no surprise given the nature of the U.S. economy. And, while mine is a minority view, I expect China would ultimately win a trade war with the U.S., which suggests China will be less likely to make any serious concessions.

In short, I don’t expect any accomplishments to come out of the talks. It looks like China may not expect much progress either – the government appears to be preparing to support its economy from within by recently encouraging Chinese banks to lend more for infrastructure spending. Investors have shown again and again this year that they want to believe the tariff wars will subside rather than intensify, so be prepared for some downside volatility if the trade talks fail.

3. The bull market is poised to break records

This week, the U.S. stock market should break the record for the longest bull market in modern financial history, which ran from October 11, 1990 through March 24, 2000. The current bull market began on March 9, 2009, and if the U.S. stock market makes it to Wednesday without a significant plunge (which I’m quite sure it will), it will take the record.

This bull market has been breathtaking, with stocks having risen over 300% since the start.¹ Some strategists are beginning to issue warnings about a major sell-off in the offing. I agree that valuations in general have become stretched; however, corporate earnings have been strong, and I believe U.S. stocks are likely to continue to outperform in the shorter term given the strength of the U.S. economy and the perceived safety of U.S. stocks in the midst of trade wars. My expectation is that we will see greater volatility for stocks in the coming year, including another sell-off or two of between 5% and 10% (not dissimilar to what we experienced in February). In my view, diversification and active management remain critical strategies for mitigating risk on the downside.

4. The “fear trade” continues to favour Treasuries

The 10-year U.S. Treasury yield is indicating some fear among investors, finishing last week at 2.86% despite data suggesting strong global growth.² U.S. Treasuries continue to be the perceived safe haven of choice for most investors, at the expense of other historical safe havens, such as gold.

I continue to be surprised by the way investors have largely ignored gold in the past decade. However, the unpopularity of gold has intensified in recent months, with the level of gross short contracts on gold at its highest mark since 2001; there is now a net short position in gold.³ This is certainly at least partially a function of the strong U.S. dollar, but it calls into question whether we are experiencing something of a paradigm shift when it comes to safe-haven asset classes. We must recognize that the popularity of U.S. Treasuries as a safe haven could be problematic going forward given that balance-sheet normalization is accelerating and the U.S. government is issuing more debt because it’s running larger deficits. In other words, more supply, all else being equal, suggests prices will fall.

This may be amplified by a provision in the U.S. tax-reform legislation passed last year that rewards companies for funding pension liabilities before September 15 (there is a theory on Wall Street that this has caused a spike in demand for Treasuries and that, after September 15, there will be a reduction in demand for U.S. Treasuries, pushing prices lower). However, a powerful countervailing force is the significant number of short positions being held on U.S. Treasuries – yes, there is a lot of speculation in Treasury markets as well, and that speculation significantly increased in recent weeks, according to the Commodity Futures Trading Commission. These positions may need to be covered if the “fear trade” begins buying more Treasuries (this could be triggered by a variety of risks), which could in turn send prices higher.

5. What insights may come from the Jackson Hole symposium?

This coming week, the Federal Reserve Bank of Kansas City is holding its annual Jackson Hole symposium, with many meaty topics to be discussed. The most anticipated speech of the event will likely be that of Fed Chair Jay Powell, who is set to deliver his remarks on Friday morning.

Six years ago, at this same symposium in Jackson Hole, Fed Chair Ben Bernanke spoke about non-traditional monetary-policy tools such as quantitative easing (QE) – in particular, he covered the cost-benefit framework of using such experimental tools. He noted that one potential cost of QE is that it could “reduce public confidence in the Fed’s ability to exit smoothly from its accommodative policies at the appropriate time.” I am hopeful that Powell will address balance-sheet normalization given that the Fed’s exit does not appear entirely smooth, as it has created liquidity issues for emerging-markets countries – so much so that the Reserve Bank of India Governor Urjit Patel wrote about his concerns in a Financial Times op-ed piece in June: “Dollar funding has evaporated, notably from sovereign debt markets. Emerging markets have witnessed a sharp reversal of foreign capital flows over the past six weeks, often exceeding $5 billion a week. As a result, emerging-market bonds and currencies have fallen in value.” If not at Jackson Hole, hopefully we will glean more about balance-sheet normalization from the minutes of the most recent Federal Open Market Committee meeting, which will be released this week as well.

In my next blog, I’ll highlight news from Jackson Hole, as well as any surprise news that impacts global markets.