Mid-week market update: The latest update of Bloomberg Intelligence Market Pulse Index shows that it’s at manic levels.
The market seems to be ignoring tail-risk, which is an increasingly worrisome development.
Inflation risk
Stock prices have held up remarkably well in the face of worries about DeepSeek, Trump tariffs, geopolitics, and other economic developments. Take today’s hot CPI report, as an example. Core CPI came in higher than expected, which dampened any expectations of a rate cut in the near future.
Moreover, the University of Michigan inflation expectations report had a glass half-full and half-empty quality. Inflation expectations rose overall, but expectations were highly bifurcated depending on the political views of the respondent. Republicans expect zero, or near-zero, inflation, but Democrats expect inflation to surge. The glass half-full interpretation is this sentiment survey has become useless as it just reflect political partisanship. The more ominous glass half-empty interpretation is inflation expectations are becoming unanchored to the downside for Republicans and to the upside for Democrats, which is an unwelcome development for Federal Reserve policy makers.
Sleepwalking into a trade war
The market also seems to be ignoring the risks of a trade war. When Trump announced a 25% tariff on Canada and Mexico, and 10% tariff on China, stock prices fell, but recovered when Trump walked back and delayed the tariffs on Canada and Mexico for a month. It barely budged when he announced additional tariffs on aluminum and steel imports, and reciprocal tariffs on unspecified countries. This was in the face of Ford CEO warning of the aluminum and steel tariffs causing chaos in the auto industry (see
CNBC report).
Similarly, the stock market didn’t react to trade war in 2017-2018 until it stared the news in the face.
Other risks
The market seems to ignoring other key risks. The House and Senate can’t seem to agree on a budget. Even if Congress were to agree on a bill that extends the TCJA tax cuts, which is an important Trump legislative priority, its passage doesn’t inject additional economic stimulus because it represents the status quo. Not known are the extent of spending cuts to pay for the tax cuts, which represents fiscal contraction that poses a headwind to stock prices.
As well, Trump threatened that “all hell would break loose” if Hamas doesn’t release all of its hostages by Saturday. His belligerent remarks puts the Netanyahu-led Israeli government in a difficult position, as it can’t be seen to be hawkish than Trump. Conceivably, the tail-risk of an attack on Iran could grow if the Saturday deadline is passed without a satisfactory resolution.
We are approaching a seasonally positive period for the VIX Index, which raises the odds of a volatility spike in the near future.
In the meantime, the SKEW Index, which measures the price of hedging downside tail-risk, is at elevated levels since the election but readings aren’t extreme.
Be prepared.
As they say “markets can stay irrational longer than one can stay solvent”
Whenever sentiment is at a record high, it had to exceed the prior sentiment high, which makes sentiment a poor timing tool, but it does warn that things may change.
It’s similar to “when everyone buys, who’s left to buy?” Only we don’t really know when no one is left to buy, we just know that at some point the sellers will be all by themselves.
What we don’t know also is if we get a melt up spike circa dotcom /1929 or a more rounded process like late 60’s SPX in 2000, which gives more time to exit longs.
actually, I think there was pretty much time to exit longs from March 2000 onwards. Things were reasonably OK until around September. Same with 2007/2008; plenty of ample warnings.
What always makes me nervous is the potential for something like 1987 or 2020. In the case of the former, none of my signals gave due warning. For the latter, only a few signals were valid.
I think TCJA presents a headwind to the economy. If renewed, how is it paid for? If NOT renewed, increased taxation on corporate America and individuals. Which is better??
Trade wars are a headwind depending on how long they last and the final structure. Stronger dollar is helpful to. American consumers.
Too many known unknowns.