If the markets were left to their own devices and to fend for themselves, the S&P 500 would be nowhere close to the 2650 level, but perhaps linger around the lows of December or possibly lower. Central banks are all too aware of the macroeconomic uncertainty, which is why every time the S&P 500 falls more than 1%, threatening its support levels, tweets from U.S. department officials like Mnuchin or Trump himself appear, to tease the market that progress is being made on Trade War talks.
Despite denials that follow, markets remain supported as investors are too scared to be caught short. To add another layer of uncertainty, the People's Bank of China (PBOC) keeps pumping money into the system via open market operations, boosting short-term liquidity supporting asset prices. The Shanghai Composite stock market is up 7% since the start of this year and the offshore yuan is up from lows of 6.90 to the dollar to 6.75 today. What is happening?
It seems U.S. and Chinese central banks are literally buying time ahead of the January 30 higher-level trade talks between China Vice Premier Liu He and U.S. Trade Representative Robert Lighthizer. The fate of markets, and most asset classes, is currently hanging by a single piece of thread, which, if pulled any further, could unravel the entire system.
There is no debate that economic data reported recently paints a gloomy picture economically. Global PMI surveys to ISM, including the German IFO business expectations index reported recently, hit its lowest level since the eurozone crisis, and came in at 94.2 vs. expectations of 97.1. Both U.S. and eurozone Citigroup Economic Surprise Index are printing at lows. Economists are predicting a recession early next year, but what most don't seem to realize is that we are probably already in the midst of one. Will it be long lasting? That all depends on Trump's stubbornness and China's firm domestic policy agenda.
Fundamentals aside, liquidity is a factor that most market participants do not give serious consideration. As investors, we are trained to study financial models and analyze numbers to come to a logical investment conclusion. Factors like sentiment, consensus positioning, and liquidity are attributes that have equal, if not greater, importance. At times, they can overshadow the fundamentals. The week before last was a great example, when China pumped in 1.1 trillion yuan of liquidity into the system, which automatically made its way into financial markets, squeezing out the shorts focused purely on "fundamentals."
On Friday, as Goldman Sachs summarized, "the PBOC said that it would allow primary dealers to swap their holdings of perpetual bonds for central bank bills, and directly use those bonds as collateral to access certain PBOC liquidity operations." In layman terms, this measure will increase the capital cushions of banks and relax one of the constraints on boosting credit supply. In line with kindergarten math, more credit equals more growth equals higher asset prices. The fundamental bears are in battle with liquidity bulls.
We are in the heart of fourth-quarter 2018 earnings seasons. Of the 20% of S&P 500 companies have reported earnings so far, 75% are beating earnings estimates and 60% are beating revenue numbers. This week is a big gauge of market appetite, as bellwethers like Amazon (AMZN) , Microsoft (MSFT) , Apple (AAPL) , General Electric (GE) , and Facebook (FB) report. The earnings of these tech giants could drive the next leg of the markets given their importance and weight.
From a technical point of view, we are also threatening the top end of the downward-sloping trend lines in various markets -- according to the S&P 500 Index (SPY) German index Nordex (NDX) and (QQQ) . The market can go either way from here.
One thing is certain, if the impasse in trade talks continues, approaching the March 1 deadline where U.S. tariffs will increase from 10% to 25% on $200 billion goods, the market will take a new leg lower. If there is a delay, then the sideways churn will continue. If China manages to appease Trump and the U.S. calls for intellectual property rights and stronger constraints on technology theft, the market can easily shoot higher as most investors are underweight equities given the debacle of 2018.
The Fed FOMC meeting commences as well on the January 30. It will be interesting to see if they change their tack, given the 8% rally in markets since Fed Powell introduced the word "patient" in his commentary. The Fed will probably stick to their "dovishness" to buy themselves time, as well.
Given the binary outcome, investors are best advised to sit on the sidelines until the events of this week unfold.