David Rosenberg is the chief economist and strategist for Gluskin Sheff + Associates Inc. and author of the daily economic newsletter Breakfast with Dave.
For the second time this year, the Dow has entered into an official correction mode, with a decline of more than 10 per cent from its recent highs. All three of the major U.S. indexes just registered their biggest percentage weekly decline since January, 2016. Those pundits who put on their "don't worry, be happy" face and blamed the late-January/early-February market plunge on nothing more than a "flash crash" type of event, are wiping egg off their face.
Don't think for a minute that trimming back on decades of globalization should not lead to a shift lower in whatever your estimate of the fair-value price-to-earnings multiple is. A trade war, no matter how well justified, is a squeeze on real incomes and margins; and government spending like this, at this stage of the cycle, will only make the U.S. Federal Reserve's job that much harder.
On the trade front, what investors are responding to is China hitting back with its own levy of 25 per cent on imports of U.S.-made goods. But it is not the size that is the issue but rather the response itself and this gnawing feeling that the retaliation isn't over. Keep in mind that the U.S. actions have not been limited here to just steel and aluminum, but also include robots, rail equipment, electric vehicles, advanced IT products and drugs, while also blocking Chinese investment in strategic sectors (this amounts to action that affects US$60-billion of annual imports from China). No doubt, the President campaigned on protectionism, but so many of his supporters thought this was mere rhetoric. But it is now policy, aimed at supporting his Rust Belt base. For those of us in the investment business, this represents a new source of market uncertainty.
And keep in mind that the President's latest firing of H.R. McMaster and hiring of John Bolton as national-security adviser signals a significant shift away from diplomacy and more toward a very hawkish foreign-policy stand. At the same time, Congress has passed a whopper of a spending bill, on top of the huge tax cuts, which are going to cause the fiscal deficit to balloon.
It will be interesting to see how future Treasury auctions go, seeing that half of the U.S. budget shortfall was funded by the foreign investor last year. This may be just a tad more difficult to do when you are busy sparring with your trading partners (especially in Asia, the principal financers for America's high-flying lifestyle).
The reality for Americans is that Japan and China own nearly US$4-trillion of U.S. securities. So this belligerence out of the White House could lead to what is otherwise known as the law of unintended consequences – more specifically, the implications of what these countries end up doing with respect to their current mix of global assets and their heavy U.S. weightings. This is where Mr. Trump is wrong: There is no winner in a global trade war – just varying degrees of losers.
The mantra is how wonderful the global economy has been doing – the operative word is "has," not "is" – as so many analysts, economists and strategists seem to like to forecast by looking through the rear-view mirror. The Baltic Dry Index has visibly rolled over, and this is a leading indicator. Investment-grade credit spreads have widened out 20 basis points, which represents a 20-per-cent move from the nearby lows. The yield curve is as flat now as it was in November, 2007. Copper has corrected nearly 10 per cent to a 14-week low and is at a critical technical juncture. And yet the typical talking head on bubblevision continues to wax about how great the investment backdrop is. There is no shill shortage, that much I can assure you.
We are in a period of major transition, across a wide front, highlighted by the VIX, which so far this year has averaged 50-per-cent higher than all of last year (one of the most tranquil ever). History shows us pretty vividly that when we enter into such a heightened state of volatility, something big, as in a game-changer, is in the offing. Call it a shift in the secular paradigm:
- From monetary easing to monetary tightening – rate hikes already in the United States, Canada and Britain as well as tightening biases in all three countries; tapering in the euro area.
- From fiscal responsibility, or some semblance thereof, to fiscal recklessness – not just massive tax hikes late in the cycle, but a public-sector spending boom, too.
- Decades of declining trade frictions and freer trade flows to overt protectionism.
- Years of disinflation giving way to moderately higher inflation.
- The rising tide of global populism has not gone away at all.
- Come November, one-party GOP rule gives way toward a split government as the odds of the Democrats taking the House, at the very least, are high, ushering in a renewed period of policy sclerosis.
- Years of a steep yield curve forecasting solid growth has morphed into a sharp flattening – if the stock market had been prescient on fiscal reflation working, the coupon curve would have been steepening (and the dollar rising), but this never did happen. Now we have the spread between seven- and 10-year T-note yields a mere eight basis points away from inversion.
- The era of growth investing is over and the exclamation mark was the user data scandal at Facebook, whose stock is down more than 15 per cent from the highs; but Google also is down more than 11 per cent, and Apple and Netflix are both off more than 7 per cent. Shades of Cisco, Lucent and Microsoft circa 2000.
So, how to survive this transition – keeping in mind that we are classically late-cycle here:
- Raise some cash. You will be rewarded in coming months as liquidity shortages occur and the few able buyers will be taking the plethora of forced sellers out of their long risk positions.
- Prune your equity portfolio – fewer names, and ones with high ratings, cash on the balance sheet and relatively high earnings visibility.
- Buy inflation protection for the near term – gold, oil, Treasury Inflation Protected Securities. Energy companies in North America have amazing risk-reward attributes at the moment.
- Hedge interest-rate risk via credit alternative funds and short-term floating rate notes.
- Focus on balance sheet quality and avoid companies that have refinancing risks.
- Focus on value, take profits on growth stocks. There are deep-value special situations out there with minimal correlations to the U.S. economy.
- Zero-coupon bonds as a hedge against recurring flight to safety.
David Rosenberg