If not in 2018...
“Assuming that tax reform is passed, the conventional wisdom among many policy types is that we wouldn’t see a downturn until 2019, as a massive corporate tax windfall would be ploughed straight back into markets, and the wealth effect would buoy the economy through the midterm elections, and quite possibly through to 2019.”
Rana Foroohar, Financial Times, 18 December 2017
I think it would be fair to say that the ‘normal’ way of writing an outlook for the coming year is the tour d’horizon of key events, risks etc. Certainly, this has been my approach in the past. However, it seems to me this year that the biggest single ‘known unknown’ for investors revolves around the timing of “the next big market correction”, which Rana Foroohar (quoted above — subscriber access only) reckons “any FT reader knows [is] coming” (and I am sure FT readers are far from alone in this!). As Ms Foroohar continues: “The question, as always, is when the penny drops”.
While acknowledging that this, indeed, may not happen until 2019, she goes on to speculate that it may come sooner — possibly even before the US midterm elections on 6 November, with potentially critical implications for the outcome thereof. And she cites as as potential triggers the Fed’s balance sheet deleveraging and the backlash against the FANGs (ie Facebook, Amazon, Netflix, Google) which is now gathering momentum and which she believes could have a significant impact on tech stock valuations.
It is not the business of a mere politics ‘hack’ to postulate over the actions of he Federal Reserve, any more than I at least am qualified to wax lyrical about tech stock valuations (even though there is certainly a regulatory — and therefore, ‘political’ — dimension to the latter). But there are other potential causes of a major correction which are fundamentally political.
I should be clear at this point that I am not saying categorically that the bubble will burst at some point in 2018. After all, at this stage last year things were not looking particularly good for the then coming 12 months, only to turn out much better than (probably) most forecasters were predicting. But I think we shall have to be very fortunate to get through 2018 without some sort of crisis. In short, I have much sympathy with the lead note in the 28 December edition of the Economist Espresso, headlined “Pulling the punch: financial markets” and reading as follows:
“Economics outweighed politics as far as the financial markets were concerned in 2017. Investors may have taken occasional fright at President Donald Trump’s bellicose tweets, the slow progress of Brexit or populism in Europe. But their attention quickly switched back to the main theme of the year: economic growth forecasts were upgraded and inflation remained low. As a result the two potential stockmarket bogeymen — a recession and rapidly rising interest rates — were kept at bay. Subdued inflation also meant that government bond markets defied the bears for yet another year with yields staying at low historical levels. But politics could bite back in 2018 if tensions rise further between America and North Korea, or between Saudi Arabia and Iran. And it is far from clear how markets will cope as central banks continue to withdraw their monetary stimulus. But who wants to spend the Christmas holidays thinking about the punchbowl being snatched away?”
I therefore find myself not quite in the same (contrarian) camp as Ambrose Evans-Pritchard of the Daily Telegraph, predicting on 13 December that “the ‘everything bubble’ is about to burst”. But, consistent with my assessment of three political risks I outline below, I do think that there is a non-negligible probability that we may see the bubble burst this year. And I certainly think that the second part of Mr Evans-Pritchard’s headline is totally justified, ie “is the world prepared?” for this, a question to which I shall return later.
The President under pressure
I was wrong! Contrary to my prediction right up until late November that tax reform would not be done before the end of Mr Trump’s first year in office, as we all know the President signed the bill into law last month to record what was his first major legislative success. In the end, the imperative of the now fast approaching midterms outweighed divisions among Congressional Republicans, no doubt propelled in significant part by what appears to be a mounting ‘blue wave’ across America.
Although Mr Trump himself is not (of course) standing, the outcome of the midterms does really matter to him, if only in that were the Republicans to lose their majority in one or possibly both houses it would reflect badly on him personally, not least since his party’s fortunes are inevitably tied to an extent to his personal approval ratings.
Even if this were not the case, it would be fair to assume that, of the three metrics with which Mr Trump appears to be preoccupied, this is the one which seems to matter most to him. (The other two are: stock market valuations, for which he will almost certainly come to regret claiming credit -- a claim which will at least have some legitimacy thanks to the passage of tax reform -- when the bubble does burst; and bilateral trade deficits.) For some months now, these have been pretty much range-bound between 36 and 38% (at the time of writing the RCP average has Mr Trump at 39.3% compared to a 56.4% ‘disapprove’ rating), an historic low for a president at this stage of his term of office. However, history suggests that these could improve over the coming months (or they could, of course, slide further). And we may be sure that the President will do everything he can to boost his ratings. Indeed, there are increasingly clear signs that he is setting the stage to deliver on at least some of his pre-election commitments on trade, which would play strongly with his base including white working class voters.
Furthermore, there is a second reason why I believe Mr Trump will be looking to deliver increasingly on those pledges in the coming months, ie the increasing pressure which he is likely to come under despite his pushing through the tax reform bill (which, let’s remember, is supported by only around one-third of Americans according to pollsters). When Mr Trump is under pressure the established pattern is that he seeks distractions.
The most likely source of this increase looks to me to be Robert Mueller’s investigation into Russian interference in the US election. The increasingly strident efforts of the Republicans to discredit the investigation firmly underlines, to my mind, the degree of worry which it is causing in the White House. As Perry Bacon Jr wrote recently for FiveThirtyEight:
“All of this jockeying is probably about whether [Mr] Mueller will indict either the president himself or, more likely, Jared Kushner, [Mr] Trump’s son-in-law and one of the few people who has had senior roles in both the 2016 campaign and the White House. It’s not clear whether there are sufficient charges to indict [Mr] Kushner, but there are indications that he is under serious scrutiny from [Mr] Mueller. A Kushner indictment would be a huge setback to [Mr] Trump, not to mention its family dimensions, so scuttling it is likely to be important to the president.”
Mr Bacon goes on helpfully to air four possible Republican goals summarised here in increasing order of importance (ie least likely first):
- Preparing the ground to fire Mr Mueller. Mr Bacon comments as follows:
“Would congressional Republicans move to impeach [Mr] Trump if he fired [Mr] Mueller? I’m not sure. Here’s what I’m more sure would happen in the wake of a [Mr] Mueller firing: There would be huge protests across the country; some Republicans (at least outside Congress) would join Democrats in slamming the move; [Mr] Trump’s already low poll numbers would plunge further; Democrats would become even bigger favorites to take control of the House in the 2018 elections; and a Democrat-controlled House would move to impeach [Mr] Trump almost as soon as it started meeting in January 2019. Dismissing [Mr] Mueller would effectively end [Mr] Trump’s presidency as we know it, so it would only make political sense if [Mr] Mueller were about to end [Mr] Trump’s presidency as we know it anyway (with an indictment of [Mr] Kushner or the president himself).”
- Trying to “browbeat” Mr Mueller into backing off from further indictments, even though, as Mr Perry acknowledges, nothing in the Special Counsel’s history suggests that he is likely to be intimidated.
- Trying to turn public opinion against the investigation. This looks to be no easy task. As Mr Perry also notes:
“A recent Quinnipiac poll showed that 58 percent of Americans felt [Mr] Mueller was conducting a fair investigation, about 20 percentage points higher than the president’s approval rating in the survey.”
- Boosting anti-Mueller sentiment within the Republican Party to minimise any risk of successful impeachment should the Democrats gain control of one or both houses of Congress. Mr Perry cites evidence that this is already working.
Assuming that Mr Perry is correct (as I believe he is) that Mr Mueller will not be intimidated, which suggests a non-negligible probability of more indictments to follow including of (at least) one individual even closer to the President, I think we should expect something akin to a frenzy of activity from the White House to consolidate further Mr Trump’s base and to distract.
Some of this activity will certainly be domestic — most notably, I think, around the President’s deregulation agenda, especially where he is able to pursue it without troubling Congress. For the reality is that Mr Trump’s first major legislative success could also be his last, at least as far as his current term of office is concerned. [Note: I must underline that the last twelve words in the preceding sentence do not mean that I am forecasting a second term for Mr Trump — although I certainly do not rule out the possibility.] In the immediate future, legislators are likely to be preoccupied with the pressing issues of a spending bill (if a partial government shutdown is to be avoided), the debt ceiling and additional relief for hurricane victims, plus reviving the children’s health insurance programme and addressing the issue of the ‘Dreamers’ (which could prove particularly tendencious if Mr Trump insists on attaching funding for his wall to this issue). The repeal of the individual mandate in the tax reform bill ensures that healthcare will again be on the agenda too (much as many Republicans may wish it otherwise), together with (possibly) broader welfare reform. And it appears that Mr Trump has not given up on infrastructure renewal, with a plan now expected to emerge from the White House this month. However, especially given the Republicans’ now wafer-thin Senate majority, how much of this can be done without at least some Democrat support and the extent to which this is likely to be forthcoming are very big questions.
One way or the other, as is very much the norm at this stage in the electoral cycle, it does seem likely that the President will have to turn increasingly to foreign policy if he is to rack up further newsworthy successes.
“…an issue that Americans aren’t thinking about very much now — say, a military confrontation with North Korea — could be pivotal in the 2018 and 2020 elections”.
I very much agree with the principle Mr Silver is expressing here, ie the non-negligible probability that Mr Trump will resort to some sort of ‘Wag the Dog’-type action at some point in 2018. And there are three possible 'known unknowns' in particular where I believe Mr Trump could act in ways which pose a systemic risk to the world economy, ie:
Of the three possibilities, I actually see North Korea as the thinnest tail risk for at least the first half of the year, putting a trade (which I include under ‘foreign policy’) at the top of my list and some sort of military action against Iran at number two.
A systemic shock?
“The combination of low yields and low volatility facilitates the use of leverage by investors to increase returns, and we have seen a rapid growth in some types of products that do this.”
Tobias Adrian, Director of the IMF’s Monetary and Capital Markets Department, 30 October 2017
The question which then arises is what impact any one of these three events could have on financial markets. My immediate answer is that each could well trigger a significant increase in volatility in equity markets with uncertain consequences. This is, as the quote at the start of this section makes clear, a source of considerable concern to the IMF. And it is one which, to judge from meetings in which I have participated over the past several weeks, I am finding is shared increasingly by my clients.
Which takes me back to Ambrose Evans-Pritchard’s question cited at the start of this article, ie "is the world prepared?".
My personal answer to this question puts me squarely with the IMF, fretting about low volatility in an environment which is rich in political risk.
Nevertheless, this (and the stellar performance of equity markets) is not, in my view, a reflection of investor complacency over political risk. Thus, I don’t quite agree with Rana Foroohar’s assertion in her article I quoted at the outset that markets will not care about North Korea “until the bombs are actually falling” — they do! But she is, I believe, correct when she allows that: “part of this is about the inability of the Street to price political risk”. After all, how could anyone reasonably price in the risk of war (nuclear or otherwise) on the Korean peninsula (for example)? As John Plender put it in an article published in the FT in mid-November (subscriber access only):
“As for North Korea and other threats to peace and stability, the Vix no more does geopolitical risk than do the wider markets. Since 1914 and further back markets have tended to respond to such things only after the fact. This is not illogical. Whether geopolitical risks will turn into events that entail the use of force and inflict damage on economies is inherently unforecastable.”
As a consequence, the quest for yield will continue to rule in the coming months, driven in significant part by the low volatility environment. And if it does turn out to be the case that the bubble is burst by a political event, ‘the world’ will almost certainly not be prepared for it whether this were to occur in 2018 or at some point in the more distant future.