Callum Thomas of Topdown Charts recently argued for the emergence of a global cyclical rebound based on a synchronized central bank easing. Such a scenario of rising inflationary pressures is a signal of a renewal of cyclical rebound in demand.
I have some sympathy to that view. I have been bullish on gold for some time, and gold is the classic hedge against unexpected inflation. On the other hand, it runs contrary to my observation that the S&P 500 is undergoing a topping formation (see A Long-Term Sell Signal?).
What’s the real story?
What cyclical rebound?
Tactically, I can see few signs of a cyclical rebound in the U.S. The Citi Economic Surprise Index, which measures whether economic releases are beating or missing expectations, has been weak.
The relative performance of major cyclical industries doesn’t exactly scream “cyclical reflationary rebound” either. All industries are flat to weak.
Can China lead the way?
Where will the rebound in growth come from?
A clue can be found in the latest BoA Global Fund Manager Survey, which reported that respondents were all bulled up as cash levels are at a 15-year low. Global institutions believe the most bullish development is an acceleration in Chinese growth.
Indeed, the market has become excited over Xi Jinping’s embrace of Chinese business moguls, including the formerly ostracized Alibaba founder Jack Ma. The initiative has lit a fire under Chinese internet stocks. The Chinese Internet ETF (KWEB) surged to test a key resistance level. An upside breakout opens up enormous upside potential as it would represent a breakout from a multi-year base.
Could China be the source a global cyclical rebound?
I am skeptical for two reasons: KWEB appears overly extended in the short-term; and a definitive upside breakout seems unlikely. As well, a review of the relative performance of China and other Asian stock markets shows that regional markets are not confirming the China revival theme. I interpret this as a sign to fade the enthusiasm over the prospect of a China-led reflationary rebound.
The trade war threat
By contrast, the greatest potential headwind to growth is a potential trade war. To be sure, trade patterns have significantly changed in the last quarter-century. The U.S. was the dominant global trade partner in 2000, but China now occupies that position. President Trump has chosen to respond with the imposition of tariffs to reshore manufacturing to the U.S.
According to Robin Brooks, China’s trade surplus excluding commodities has been steadily growing and the biggest culprit is the chronic undervaluation of the Chinese yuan. This analysis led Bloomberg Chief U.S. Economist Anna Wong to conclude that her baseline is a U.S. tariff rate of 45% on Chinese imports, which is not in anyone’s spreadsheet models.
The tariff threat creates uncertainty for corporate executives, which will delay plans for capital expenditures and new hiring. Mentions of “tariffs” in earnings calls have exploded upwards.
The tariff list is growing almost every day. Trump has imposed an across-the-board tariff rate of 25% on Canada and Mexico, 10% on China, 25% additional tariffs on aluminum and steel imports, and reciprocal tariffs on other countries. He also threatened a tariff of about 25% on autos, semiconductors and pharmaceuticals which will go into effect on April 2. Many of these initiatives have the potential to cripple U.S. economic growth but the market has shrugged off the potential effects. The Budget Lab estimates that just the implementation of the announced reciprocal tariffs would raise the effective tariff rate to 13%, a level not seen since 1937.
While company analysts haven’t revised their earnings estimates because the actual details of the tariffs aren’t known, Street economists and strategists have scrambled to quantify their effects. As examples, Goldman Sachs chief economist Jan Hatzius found that capital expenditure plans will fall -1% on quarter-over-quarter basis for companies with high sales exposures to Canada, Mexico and China. BoA quantitative strategist Savita Subramanian projects that S&P 500 earnings could fall by as much as -8%.
The release of the January FOMC minutes revealed some concerns about the inflationary effects of potential tariffs. The Fed’s base case called for inflation to slow gradually: “Participants expected that, under appropriate monetary policy, inflation would continue to move toward 2 percent, although progress could remain uneven”, but “other factors were cited as having the potential to hinder the disinflation process, including the effects of potential changes in trade…policy”. In contrast to Trump’s first trade war when businesses showed a greater propensity to absorb some of the tariff increases: “Business contacts in a number of Districts had indicated that firms would attempt to pass on to consumers higher input costs arising from potential tariffs”, which raises the odds that the Fed would stay on hold for longer in its rate cutting cycle.
The market doesn’t seem to be discounting these aforementioned risks, which is consistent with the Wall Street adage that the stock market takes the stairs up and the elevator down. I believe the odds of rising tariffs and a trade war are higher than what the market is pricing. Trump’s desire to address trade imbalances has long been a bedrock initiative of his political campaign. In addition, the Trump Administration regards tariffs as a useful revenue source to offset the cost of the TCJA tax cut extension, which is another important legislative priority.
In conclusion, the backdrop of synchronized monetary easing by central banks around the world should lead to a global cyclical rebound under normal circumstances. However, market internals in the U.S. and Asia are not supportive of the cyclical rebound scenario. The market isn’t discounting the very real threat of a trade war, which threatens to derail the current cyclical equity bull.
This is trying times. Americans’ tax burden has reached such a hign level that people might start to lose motivation. The national debt level also is astronomical. Obviously the current trejectory can’t go on. Change is necessary but may be painful. Still much better than doing nothing. Things will be more clear once fed gov audit is completed. The first step.
Everyone wishes the deficit could be lower, but keep in mind that fiscal contraction tends to be equity bearish because there’s less liquidity sloshing around in the system. Short-term pain for long-term gain.