I have been talking about the theme of disruption for well over a year. Last week’s tumultuous G7 meeting, and this week’s key U.S. Federal Reserve (Fed) meeting, illustrate exactly why this topic remains in the forefront of my concerns.
All eyes were on the G7 meeting last week. Some are referring to it as a “G6+1” – but that may be too generous. Given the outcome, it may be more accurate to refer to it as “G6 versus 1.” The summit began and ended acrimoniously. Before arriving at the event, U.S. President Donald Trump suggested that Russia be readmitted to the group, which many members found offensive given that Russia has not reversed its annexation of Crimea (the reason for its expulsion) and is now the object of criticism for its alleged attempts at election meddling in various Western nations. It is hard to forget British Prime Minister Theresa May’s angry accusation that Russia was attempting to undermine Western institutions and “threatening the international order.” (One can only assume she similarly would find the restoration of a G8 that includes Russia a further disruption of the international order.) After leaving the summit, Trump refused to sign the traditional communiqué that comes out at the end of the meeting and had particularly harsh words for Canadian Prime Minister Justin Trudeau. It was an unusual start and finish to the summit but this should no longer come as a surprise: disruption begets disruption.
As expected, a major source of acrimony at the G7 meeting was the topic of trade. At the risk of sounding like a broken record, I believe tariffs are a grave concern. Not only do tariff wars offer a high potential for negative impact, but I see a higher probability of a tariff war actually occurring – more so than most economists/strategists. My concern isn’t just that tariffs add to input costs, but also the economic-policy uncertainty created by the current trade tensions. As I’ve said before, such uncertainty has historically led to lower business investment, and I believe it’s happening again now.
G7 trade tensions signal a possible shift in alliances
My concern with last week’s G7 meeting goes beyond the possibility for tariff wars. The tension underscores the greater issue of shifting alliances, which I have worried about for nearly two years. In particular, by imposing tariffs on close allies – with the rationale of alleviating national security concerns – the U.S. runs the risk of alienating those allies, which may prove problematic when foreign-policy/security issues arise and their help is needed. Recall the enormous support the U.S. enjoyed when it invaded Afghanistan following the September 11 terrorist attacks; the United Kingdom rushed to support the U.S. and send troops to Afghanistan, and was later joined by Canada, Australia, Germany and others. It is also worth noting that in a November 2017 speech, Prime Minister May warned Russia that “the U.K. will do what is necessary to protect ourselves, and work with our allies to do likewise.” But recent developments call into question which allies the U.K. can really rely on and share information with, and which it may withhold some intelligence information from.
Often, disruption can be a positive – think of the beneficial outcomes that can result from creative destruction. However, in this case, I worry that shifting political alliances are likely to be more negative than positive, with implications for issues from military actions to the fight against terrorism to cybersecurity. However, as with tariffs, the impact on those issues is hard to quantify because we don’t know how this will play out – there are so many possible outcomes at this juncture.
Disruption can be a positive force as well
Turning to Italy, while I find its leadership may create negative disruption vis-à-vis foreign policy given its closer relationship with Russia, I continue to believe it will not leave the European Union (EU). Last week, Italy’s new Prime Minister, Giuseppe Conte, laid out a vision for Italy and its relationship with the EU, one that involves reforming immigration rules and alleviating its difficult debt situation – but without austerity. These are not unreasonable goals, in my view, and I believe Italy will be able to reach a compromise with the EU that is satisfactory to both parties. It behooves both to do so. From my perspective, this is a situation in which geopolitical disruption could result in positive developments.
I am such an optimist that I am even hoping that geopolitical disruption in the form of U.S.-North Korea talks can offer the potential for positive developments as well. The meeting between the U.S. and North Korea in Singapore this week is certainly a unique development that presents the potential for positive upside over the longer term.
Central banks are causing disruption as well
I’m not only watching geopolitical disruption; I’m also monitoring monetary-policy disruption as central banks, which have wielded incredible power over markets and the economy for a decade, continue to exert substantial influence.
One of the most important items on the calendar for this week is the June Federal Open Market Committee (FOMC) meeting in the U.S. The May FOMC meeting minutes revealed concern among some participants about the potential for an inverted yield curve. That raises questions about what the Fed will do beyond June, since a rate hike in June seems like a fait accompli. The statement and especially the dot plot from the June meeting will likely provide some important clues. I expect the Fed is likely to raise rates again in September, but I don’t think it’s likely that it raises rates a fourth time this year.
And that relates to concerns about the potential for an inverted yield curve. I think the Fed may consider accelerating balance-sheet normalization in lieu of an additional rate hike this year if it deems further tightening is needed, which could help reverse the yield-curve flattening that is going on. However, it could also create downward pressure for stocks and could cause problems for emerging market (EM) countries as well – some of which are already coming under significant pressure. Those concerns were articulated by Urjit Patel, the Governor of the Reserve Bank of India, in a recent op-ed piece in the Financial Times. The op-ed was an open letter to the Fed, arguing that balance-sheet normalization is working in conjunction with increased U.S. debt issuance to reduce global liquidity, which is placing pressure on EM countries with debt denominated in U.S. dollars. I have long argued that the Fed’s balance sheet is a far more powerful weapon than the Fed funds rate, and the current developments in emerging markets may cause the FOMC to treat it that way.
The European Central Bank (ECB) also meets this week. While most assume the Fed will end tapering soon, I am of the camp that believes the ECB will continue to taper as it strives to be supportive of financial markets in the face of concerns surrounding the new Italian government and its commitment to the EU. This could provide a countervailing force to the Fed’s balance-sheet normalization and U.S.-government debt issuance in terms of improving global liquidity. The Bank of Japan will also meet this week, although no surprises are expected as the central bank needs to remain accommodative and has the luxury to do so since it is far off from its inflation target.
Some emerging markets under pressure, but others still show potential
Not surprisingly given the EM pressures just discussed, some EM equities have come under pressure – particularly Brazil, where stocks posted a sizable loss for the week. I believe this pressure is not a reason to abandon EM equities, but to be more discerning in country and stock selection. For example, some EM countries may benefit from higher oil prices and already appear to be paring back on austerity. It is critical to remain vigilant about downside protection and be well-diversified; for most investment portfolios, broad diversification includes exposure to emerging markets, albeit more selectively.