It seems we are beginning to smell the faint hint of fear in markets. Not only did stocks sell off globally last week, but investors also fled to the safety of U.S. Treasuries, which drove the 10-year Treasury yield down to 2.817% – a level not seen in weeks. Last week’s market rout was the worst week for stocks in two years.
Key events from last week
A number of different factors seem to be sparking equity market volatility:
Regulation is acting as a market disrupter. The sell-off began in the technology sector, with concerns about greater regulation of social media giant Facebook. This should not have been a major source of such concern, in my view. After all, we have to expect that greater regulation should follow technological innovation – it’s part of the product life cycle. We should also assume that it takes a few years for most governments to understand both the capabilities and downsides of new technology – whether cryptocurrencies or social media – before fully embarking on regulatory scrutiny. In fact, I believe it may be time to amend Benjamin Franklin’s famous quote, “In this world nothing can be said to be certain, except death and taxes” to include a third certainty in this world: regulation.
I believe the more pressing issue afflicting the tech sector is the European Union’s announced plan to tax digital revenue. Taxing digital revenue could adversely affect corporate earnings, which is always a cause for concern.
Tariffs are raising prospects of a global trade war. Weighing more heavily on stocks last week were legitimate concerns about a potential trade war. I view tariffs much like bacteria in a petri dish – they multiply, which can stymie economic growth. In my view, the Trump administration is warranted in addressing China’s intellectual property violations through the World Trade Organization, as was laid out in a recent Cato Institute piece by James Bacchus.1 Beyond that, however, I believe it is risky to pursue tariffs for several reasons:
- Chinese retaliation in the form of tariffs could be damaging to some U.S. companies. China was the third-largest market for U.S. exports last year. Certain U.S. industries, such as aerospace and agriculture, are large exporters to China, and could be hurt by retaliatory tariffs.
- I believe U.S. tariffs on foreign goods will hurt U.S. consumers. The National Retail Federation said the tariffs will “punish ordinary Americans for China’s violations,” and could cancel out the benefits of the tax reform package enacted by Congress last year.2
- Retaliation can come in other forms beyond tariffs. As I’ve warned in the past, foreign governments could wield a far more powerful tool by curtailing the purchase of U.S. Treasuries – or even by selling Treasuries they currently own. China is the largest foreign owner of U.S. bonds, so it can have a significant impact on borrowing costs in the U.S. if it reduces, or ends, its purchases of U.S. debt. This is not just a theory. In a recent interview with Bloomberg Television, the Chinese ambassador to the U.S. said that China would not rule out the possibility of reducing its purchases of U.S. Treasuries.
Tighter monetary policy appears likely. Also placing downward pressure on the stock market were concerns that the Federal Open Market Committee (FOMC) – the policy-making arm of the U.S. Federal Reserve – will be more hawkish. With U.S. economic growth estimates revised significantly upward by the Fed, the dot plot from this month’s FOMC meeting still predicts only three total rate hikes in 2018, which I find somewhat surprising. However, that could change if signs of inflation – especially wage growth – emerge.
And while the current dot plot’s prescription for three rate hikes in 2018 might seem reassuring, the median projection for the federal funds rate at the end of 2019 is now 2.75% to 3%. This had represented the hawkish end of the spectrum before the latest FOMC meeting, and raises concerns that we could see an inverted yield curve.
Omnibus spending bill, White House revolving door are doing little to soothe nerves. I believe a couple additional factors hurt stocks last week as well:
- After overcoming objections from the White House, Congress passed a $1.3 trillion omnibus spending bill last week. The good news is that a government shutdown was averted. However, that may be outweighed by the prospect of more debt. Given U.S. dependence on overseas investors to buy its debt, we now have to worry that foreign buyers of U.S. Treasuries may reduce their purchases.
- There also seems to be slight underlying trepidation in the markets about the rapid pace of personnel changes in the White House. For so long, stocks seemed immune to the turmoil in the White House – in fact, stocks exhibited a “Teflon” effect, whereby all political developments seemed to roll off without any impact. But that may be changing, at least temporarily. One area of concern is the rising influence of protectionists – particularly Peter Navarro, a trade deficit hawk who is now President Trump’s Chief Trade Advisor. Some notable “globalists” have also departed, including former Secretary of State Rex Tillerson and Gary Cohn, who resigned this month as Trump’s Chief Economic Advisor.
- Also, by naming John Bolton as National Security Advisor to replace H.R. McMaster, I believe President Trump has increased the risk that the U.S. will be drawn into one or more military conflicts – especially given Mr. Bolton’s hawkish foreign policy views. Then there are the recent changes to the Trump legal team vis-à-vis Special Counsel Robert Mueller’s investigation into 2016 election meddling, which may be unsettling investors’ nerves.
So, yes, there does seem to be some level of fear in the market. Here it’s important to note that the move into Treasuries last week was rather modest. On one hand, this would seem to suggest that fear is quite muted. On the other hand, we might just be seeing a change in what investors regard as a “safe harbour,” given that gold prices rose last week. In fact, the price of gold has been rising at the same time silver prices are falling. This could be viewed as a sign that economic concerns are increasing. When the gold-to-silver ratio has risen in the past, it has generally occurred during times of market turmoil, such as the 2008 global financial crisis.
While this was the worst week in two years for the stock market, the big question is: Will it continue? I believe the market will continue to be very turbulent, with a tug of war between positive and negative factors. This means stocks are likely to continue to rally and then sell off, with rotations in leadership among different areas of the stock market. I’ve written before about a market with a bark worse than its bite. For those who celebrate the Lunar New Year, it is the Year of the Dog; for investors, it is the Year of the Chihuahua.
What to watch this week
U.S. consumer confidence and consumer sentiment. These indicators are likely to show that the mood of U.S. consumers remains positive. However, there is a gap between sentiment and economic activity, with sentiment more positive than actual spending. U.S. personal income and outlays are also being released this week, which should offer insight into whether consumer spending is more reflective of such positive sentiment.
Japanese retail sales and industrial production. There has been weakness in recent global data, and so it’s important to closely follow economic data in all major economies. This data should provide a good snapshot of how the Japanese economy has been faring recently.
Gross domestic product (GDP) results. Fourth-quarter U.S. GDP is likely to show strong economic growth, driven by largely by consumer spending. While it will be important to confirm this, it is far more important to follow measurements of first-quarter GDP closely, given that the Atlanta Fed GDP Now Indicator suggests more disappointing growth.
GDP estimates for the United Kingdom, which are due to be released this week, should provide a sense of economic growth in the face of great economic uncertainty, as negotiations continue for next year’s Brexit. Canada’s GDP estimates should also be followed closely, given that its central bank hit the pause button on rate hikes due to concerns that rising rates have slowed Canada’s economy.
Eurozone economic sentiment. The eurozone’s economic sentiment index provides a broad measure of both consumer and business sentiment. This should, in turn, offer clues about the direction of economic growth going forward, particularly given recent signs of weaker economic data in Europe.