If one were to look at the S&P 500's performance in August, one would think it was yet another boring summer month. Hardly. The index ferociously bounced between 2820 and 2920 as President Trump and China's Xi Jinping decided to have a headline sparring contest -- keeping the computer algorithms extremely busy as they chased both the markets down and up, day after day with no trend in sight. Disaster.
Algorithms are designed to capture headlines and trade the momentum off of them. But it is unfortunate for them, having someone like Trump at the helm deciding the fate of markets -- someone who suffers not only from extreme fickleness, but also from a heightened sense of delusion, as he imagines phone calls with China. One would think he would keep these "conversations" to himself lest people question his mental health. As the market was trying to work through the cross currents in August, algos once again got fooled by Trump on this mysterious phone call with China and started chasing the market higher.
Towards 3000, Trump gets the confidence to flex his muscles and play hard ball with China, threatening to raise tariffs from 25% to 30% on $250 billion worth of goods and potentially 15% on the $300 billion balance. Market sells off towards 2800, threatening to break the uptrend, then Trump comes out with a headline suggesting potential talks, and the market rallies! This has been the state of affairs in August.
If traders actually traded the headlines, and took his word for granted, they would be in shambles by now. Rather than react to headlines and have the market give one clues as to where it is headed, one needs to take a step back and see the bigger picture to see what the end goal is and act accordingly.
Trump is playing a very delicate game of 3-D chess between Fed Powell, Xi Jinping and his precious U.S. stock market. Trump just has this agenda: get the Fed to cut rates by at least 100 basis points and get the S&P 500 above 3000 into a new bull market by next year just in time for his re-election.
But this is a market that seems exhausted as it nears the end of its expansion cycle, profit recession is taking hold and corporate margins are shrinking. Other than fiscal stimulus, tax cuts and releveraging the economy, there seems to be no other way to achieve this.
In 2016, the tax cut boosted the earnings for the S&P 500, which resulted in a 20%+ rally in 2017. Most of the earnings beats now are due to share buyback programs inflating earnings by lowering share count -- as companies use the "cheap money" to service their debt or buy back shares as opposed to investing in the business itself.
At Jackson Hole, Powell's commentary was not as dovish as hoped for, as he maintained a "we will do what it takes to sustain economic expansion" position, without actually suggesting a cut in rates. The global bond market is at serious odds with Fed policy, as today nearly $17 trillion of global debt is negative yielding.
The inverted shape of the U.S. bond curve across all structures is begging the Fed to lower rates, as there is a huge disconnect between the two. Now the Fed, which has always been backward looking, can see the data weaken, but U.S. GDP growth is still estimated at around 1.8%, unemployment is at record lows and there is sticky wage growth. Most regional Fed surveys have started showing Manufacturing weakening, with the latest August PMI Markit printing 49.9 (below 50 signals contraction). A more troubling trend is that even Markit U.S. Services PMI showed a move lower to 50.9 from 52.8 earlier.
The resilience in the Service sector, mixed with strength in the labor market and robust consumer confidence, are some of many reasons for the Fed to argue against cutting rates too aggressively. Despite Trump using Powell as a punching bag anytime the market falls, the Fed really has not had enough evidence to embark on a 50-basis point cut per meeting trajectory as yet. After all, it does not want to show its entire hand, the Fed only has 225 basis points of rate cuts in its war chest.
After China blatantly denied any phone call with Trump over the last few days, once again showing the market how he makes things up and does not have the required decorum to conduct his job, Trump probably felt compelled to actually make a call to save face. That acknowledgement alone is not enough to warrant a deal, as the two sides are far from agreeing.
September is turning out to be an increasingly important month, as the Fed hosts its FOMC meeting on September 17, where the market expects a 50-bps rate cut, with 25-bps priced in. September 1 is also when new U.S. tariffs get imposed on China. Initially, this week China was set to impose tariffs on U.S. goods as well -- as retaliation. But on Thursday, the Chinese said they would not, as a gesture of goodwill to sound negotiations. How is Fed Powell supposed to manage this binary outcome with the market still at close to all-time highs?
Rather than be a pawn in Trump's tariffs game, this is the time for the Fed to truly show its "independence." It has the market on its side as the fall can easily be blamed on Trump and his ridiculously volatile tweets, but the Fed can be there to support the market when it needs to.
Trump has a deadline -- and it is November 2020. China knows it and so does the Fed. Trump is not doing himself any favours politically with all these rants, as U.S. farmers and the agricultural situation is dire, U.S. businesses are feeling the pinch of his tariffs and slowly the consumer will too as they pass along the costs.
The only way Trump will do a deal with China is if China gives into all his demands -- including re-shaping their domestic policy. China will never agree to that, it will only offer to buy more goods and services to balance the trade deficit. Xi Jinping will attend the 70th anniversary party of the Chinese Communist Party on October 1. He will not do anything prior to that to risk his reputation and appear weak against the U.S.
Regardless of the algos getting excited about any positive trade tweets, this is where human fund managers can still be relevant as they can analyse the psychology of the market and Trump, and be more cerebral about their investment choices, rather than just chasing a trendless market. Unless there is an actual deal between the U.S. and China, trade wars called off once and for all and economic growth ticking higher, this market has risk to the downside.