As the ten-year anniversary of the last crisis has arrived this month, it is a fitting time to be thinking about what might cause the next one. In fact, many investors, professional and retail alike, are fairly obsessed with calling the next big blow up. But what might cause it? While trade war and political strife grab a lot of headlines, the real driver of the next crisis will be the Fed. The two big worries on that front are rising rates, but perhaps even more worryingly, its shrinking balance sheet. Crises have historically happened when money supply grew tighter, and that is what is occurring right now.
FINSUM: The markets have never been through the winding down of a major QE program, so it is hard to foresee how this may playout. Logic says that the next big blowout will probably be tied to the end of easing.
Investors may not realize it yet, but the Fed is in a quite pickle: damned if they keep hiking, damned if they don’t. In what is being dubbed a potential “Dollar doom loop”, the Fed might create a cycle of excessive Dollar strengthening if it keeps hiking. This may cause an overseas debt crisis as many foreign borrowers, especially EMs like Turkey, have issued excessive Dollar-denominated debt. This would in turn put stress on Europe. Additionally, the strong Dollar strengthening would start to hurt US corporate earnings and exports, in turn weakening the economy and possibly causing the Trump administration to move to artificially weaken the Dollar. That said, if the Fed quits hiking, it risks the economy, which is already hot, quickly overheating.
FINSUM: This situation is very real, but luckily we think there is a pretty simple solution—only proceed slowly with hikes. It should be enough to keep the economy in check (given inflation is not high), but not so much as to send the Dollar surging (imperiling foreign borrowers).
Investors in stocks will be familiar with the market’s habit of focusing on an issue for a week or two, getting anxious, and then moving on almost completely once things looks even half-resolved. That is exactly what happened with Italy’s debt crisis a few months ago. However, this problem looks likely to rear its ugly head again. Italy is the third largest debt market in the world, and its looks dangerously close to imploding. That may be why Trump offered Italy funding to help its situation. The big fear is a near-term budget vote where the country’s parties are considering a package that would offer a flat tax rate and universal income for the left, all while ballooning the deficit to 7% of GDP, way above the EU limit of 3%.
FINSUM: Italy is currently led by a pair of parties that hate the Euro, so it seems likely that they may tempt fate with this kind of package. However, there is a potential compromise in the works.
The US and China ended two days of trade war negotiations yesterday, and apparently there was little progress. Both sides pressed ahead with enforcing $16 bn of further tariffs on one another. The deputy White House Press Secretary commented at the end of the negotiations that the two countries “exchanged views on how to achieve fairness, balance and reciprocity in the economic relationship”, but made no mention of any material progress being made. One senior Trump administration official added “in order to get a positive result out of these engagements, it’s really critical that they address the fundamental concerns that we have raised. We haven’t seen that yet”.
FINSUM: While the market seemed very hopeful about these talks, the trade battle with China looks likely to keep going for a while yet as the issue seems to be quite intractable.
Pimco just made the most obvious warning we have ever heard, but within it, there are some useful reminders. They warned investors that there is a 70% likelihood of a global recession within the next five years. Their reasons for thinking so, and how to handle it, are a bit different than the norm however. Their focus is on how all central banks are in tightening mode and public market assets have become very expensive. Pimco says investors can find safe haven in private markets as the recession takes hold. These include in private credit, such as in corporate loans, non-qualified US mortgages, and commercial development loans. They say returns in those areas will be 10%+ instead of 5-6%.
FINSUM: We think their drivers are correct but their timing is off. We see a recession coming much sooner, probably within two years (at least for the US). However, the private credit recommendation is a unique one, but also hard for most investors to access.
Trump spooked currency and Treasury markets yesterday. Speaking in the context of the US’ trade tussle with China and others, Trump said he wasn’t thrilled with the Fed’s interest rate hikes. He said that in the trade battle with China, the Fed should be accommodative with its policy. Trump called Beijing a currency manipulator, and said the Euro was being manipulated also. Speaking on Trump’s comments and his new consistency in criticizing the Fed, one analyst said “This is now a serious headwind to the dollar”.
FINSUM: It is true that a constantly strengthening currency is difficult to deal with in a trade war, but that the same time, the Fed’s job is to look at US economic fundamentals. That said, how rate decisions would affect the economy via a trade war do seem like they would be within the Fed’s purview.