A review of the year – clues to the future?
What a way to end the year. The Friday before Christmas saw US equities soar to fresh all-time highs on a low volume melt-up as the “triple witching hour” quarterly expiry of futures on stocks, indices and options kicked in. There were gains outside of the US as well, as that day saw the MSCI world equity index hit another fresh record close. This was the last big trading session ahead of the holiday season although Boxing Day saw new records hit as US indices built on previous gains. There was no single catalyst for this bullishness, with no fresh news on the ‘phase one’ progress made on the US/China trade deal. The buying seemed related to a desire by speculators to make sure they were long going into the holiday period and this helped to force out what few remaining shorts there may still be in the market.
Big gains in 2019
We’ve certainly come a long way since the beginning of the year. Both the S&P and the Dow Jones Industrial Average are on course to close out 2019 around 30% higher from twelve months ago. Meanwhile the Nasdaq 100 is up around 50% over the same period which shows the unabating popularity of tech giants like Apple, Alphabet and Facebook. But it is worth remembering that a year ago global stock indices were reeling following a brutal sell-off which saw the S&P 500 fall 20% between October and Christmas Day. Take out that sell-off, and the S&P is up 10% from the October 2018 high of 2,940. Still pretty good, but less impressive than the full year-on-year comparison. While there were trade tensions between the US and China, last year’s sell-off was due to the US Federal Reserve tightening monetary policy through a series of rate hikes and a steady reduction in the central bank’s balance sheet. Then at the beginning of 2019 the Fed swung from hawkish to dovish and gave up any attempt to ‘normalise’ monetary policy after years of rate cuts and stimulus. The Fed followed up on its dovish pivot by bringing a halt to its balance sheet reduction programme and then cutting its fed funds rate by 25 basis points in three successive meetings.
Balance sheet boost
This September saw problems emerge in the repo market. The Fed responded by boosting its balance sheet by $378 billion over the last quarter of 2019, further goosing risk assets to such an extent that all the major US stock indices look like ending the year at or near record highs. So much for balance sheet normalisation. The Fed’s actions have seen the US Treasury yield curve steepen at its sharpest rate since October 2018, from being inverted earlier in the year. Generally, this isn’t positive for risk assets as it’s often a signal that a recession is on its way. But the flood of liquidity provided by the Fed has overridden recession fears. The problem is that the central bank will probably need to continue expanding its balance sheet at the current rate. Any slowdown would feel like tightening in liquidity, and this could take the wind from under equity prices.
While the apparent ‘phase one’ US/China trade agreement also lifted sentiment, there’s a worry that the breakthrough means it is less likely that the Fed will provide additional stimulus going into 2020. Of course, it could be that investors will wake up to the fact that the ‘phase one’ trade deal (currently unsigned) between the US and China is as good as it’s likely to get, and Trump’s promised ‘phase two’ will never materialise. It could become apparent that China has no intention of opening its markets to foreign investors on anything other than its own terms. China may be seen as non-protective of foreign investors when it comes to intellectual property theft or forced technology transfers. President Trump may well boast about increased sales of US agricultural products to China. But the reasons why he went to war in the first place haven’t been, and won’t be, resolved in the US’s favour. Getting China to promise to buy more soya beans wasn’t Trump’s prime motivation in starting the trade dispute.
The last decade has seen central banks respond to the Great Financial Crisis of 2008/2009 by offering up unprecedented amounts of monetary stimulus. This has pushed the prices of bonds and equities to record highs. It has also meant that there has never been so much indebtedness, particularly at the corporate level. The only serious attempt by any central bank to ‘normalise’ monetary policy in the last ten years came from the US Federal Reserve last year. This came after Trump’s nomination for the Fed chairmanship, Jerome Powell, took up the position in February 2018. It ended when global stock indices responded to higher interest rates and a reduction in the Fed’s balance sheet by slumping by 20% or more throughout the third quarter of last year. President Trump had been highly critical of Jerome Powell throughout this tightening phase, going so far as to looking into ways of sacking him. As a result, it’s now impossible to know if Powell’s hawkish-to-dovish pivot at the beginning of this year was a result of Trump’s hectoring, or a genuine acknowledgement that the Fed dare not tighten monetary policy for fear of the stock market collapsing – something which really shouldn’t be driving Fed policy.
There is an understandable fear that the Fed has been politicised, which is a perception that the central bank will struggle to reverse. This is a major issue going into the new year as this coming November sees the US Presidential Election. With the Democrats in a mess over the impeachment issue, unemployment at 50-year lows, economic growth ticking along at a respectable rate and the stock market soaring, it looks like Trump’s to lose. Currently, investors are betting that the Fed leaves rates unchanged next year, although it’s likely that the President will be piling pressure on the Fed and its Chairman Jerome Powell to continue to cut rates and add stimulus to keep equity prices elevated. But the risks of financial excesses creating financial instability are rising, and a sudden jump in political and market volatility could be the surprise of 2020.