As traders are slowly returning to their desks after the New Year holidays, the market will be active in earnest this week. Friday caught most by surprise, as Powell made some conciliatory comments when he spoke at the American Economic Association meeting in Atlanta.
This was not meant to be an event of significance -- or even one being monitored for any change in commentary, especially following the recent FOMC meeting held only a few weeks back in December. There was certainly a change of tone noted. Significantly, Powell said that he "wouldn't hesitate" to adjust how quickly it lets its balance sheet shrink, if it continues to be a drag on markets.
To recap, the market is vexed by two issues, namely the Fed removing stimulus in the economy (balance sheet normalization and interest rate hikes) and U.S./China Trade War uncertainty. Until either of these issues is resolved, or market gets some form of clarity, investors will not be able to invest comfortably or with certainty.
There is no faith in financial models when the broad overview of the economy can witness a binary outcome. If the U.S. and Chinese fail to come to some sort of agreement before March 1, global trade will come to a screeching halt and we can easily spiral into a recession. If there is a resolution, then at least one can calculate the pros and cons and trade can flow, allowing for growth to gradually return.
On the first count, the Fed is currently allowing $50 billion each month to run off its balance sheet, largely a portfolio of bonds that the central bank purchased to boost the economy during the financial crisis. Not reinvesting the proceeds is effectively "tightening" the system by taking liquidity out of the system, leading to asset classes being unwound that were inflated earlier this decade on back of the free money. On top of this balance sheet normalization, the Fed has gradually been raising interest rates to reach their "neutral rate." Also, it is debatable where that is, but as per their recent commentary, they are "a lot closer to neutral" now.
Perhaps with the S&P down 9% in December, it has caught the Fed by surprise how fragile the market is, and so this commentary is a change in direction -- suggesting perhaps a Fed "put" is in place. The Fed (Bernanke, Yellen) always came to the rescue when markets dipped aggressively. With Powell, it was unclear how much he would coddle investors. U.S. high yield credit spreads are at their widest in 30 months, and financial conditions tightest in 17 months. His statements on Friday suggested perhaps a "Powell put" is in play, boosting equity markets and other oversold asset classes.
The market has rallied about 8% from the lows reached on Christmas Eve in December, where it broke through some very important levels to breach 2500 on the downside. After last week's oversold bounce from the lows into Friday's boost from the Fed, the market has regained the 2500 level, but the next level of resistance is being able to break 2600 sustainably on the upside. The only way this can be achieved is if we get a solid resolution on the trade war front. Until then, needless to say, the market will be yoyo-ing in a downward-trending range. Even bear markets can have vicious rallies that may appear to be bull markets.
There is no doubt that growth in China has fallen substantially over the second half of 2018. All the global PMI indicators, ISM, export orders and global trade data from South Korea point to a weakening macro backdrop, which has negative implications for base metal demand like copper, iron-ore, steel and so on, with a second derivative impact on the likes of oil and oil products. It is important to differentiate ones with the tightest supply conditions (copper) that will weather this weak backdrop vs. those commodities that have ample supply (oil) for the time being compared to their demand.
All asset classes have a correlation of one, currently, and whether we would like to fool ourselves into believing we are "creating" alpha, everything will move in the same direction until the broader picture is clear. Some will move more and some less -- this gets back down to the quality of the underlying investment. In a downward tape, leveraged names and weak balance sheet companies will get hit more, and vice versa on the upside.
There is selective value out there. Stick to fundamental core names with solid earnings visibility upside, not only because they are cheap. Choose commodities where this genuine tightness in physical markets is supporting prices. On signs of stability, copper will be the first one to bounce.
U.S. and China are to hold high level talks starting Monday through Tuesday. Will it be yet another bogus positive tweet by Trump lacking in any detail whatsoever (the market is immune to this by now), or a real solution? A "show me the agreement" mantra is being echoed across trading floors as we await headlines. Until then, choose your investments wisely, as the market can very easily go back to retest lows on lack of any resolution.