Trump-Xi G-20 Pose Crash Risk for Monday December 3rd
Last week I spent a lot of time thinking and reading about the events of the 1987 crash. One of the catalysts for the crash back then was a heightened degree of trade deficits (sound familiar?) with a specific focus on Germany. On October 14, 1987, the US announced a larger than expected trade deficit. In response, Treasury Secretary James Baker got tough with U.S. trading partners. Baker’s message on Saturday 17th to Germany was “if you don’t lower rates, we’re going to lower the dollar and you’re going to have export problems.” Turns out the US has been fighting trade wars since the US and Germany broke the Bretton Woods agreement and took the world off the gold standard in 1971. Ever since, currencies have been a trade war tool. Have a look at what China did in the 1980s? Not only do they have a labour cost advantage, they have a massive currency advantage too. You can see why the 7 CNY level is so important. When the US agreed to allow China into the WTO, part of the agreement was to let their currency strengthen.
Today, Treasury Secretary Steve Mnuchin is likely going to be fired soon by Trump. So it may no longer matter what he has to say. Friday we saw Trump remark that Mnuchin is better at producing movies and should probably go back to that—I mean really, he’s just the money guy, he did not write them. We know from Trump’s Twitter feed he is not happy with the Fed’s rate hikes. He probably does not understand his tax cuts are responsible for the firmer path of rate hikes. And likely does not understand basic economics. He thinks he is responsible for oil prices falling. Well, we can be sure he does not understand a lot of things from his Twitter feed. His meddling in regards to the Fed’s independence is a crucial policy error from Trump.
I often like to go back in history and look for periods of similar risks to see what investor behavior might be like. They say history does not repeat, but it rhymes an awful lot. The 1987 was not exactly like the current market, but it was similar. Earlier this year I looked at a study done by Jeremy Grantham, a European based value manager (www.GMO.com), that paralleled the 2017 run up into the spike in early 2018. He considered that the fear of missing out could still drive the markets much higher like in the late 1920s. So far he’s been wrong. We did see a higher high for the S&P 500 in September, but it died rather swiftly. The one main thing in common with 1987 is that we saw a 10% correction earlier in the year followed by a new highs and then another 10% correction followed by the crash. Let’s just say the set up is eerily similar. While I don’t think (hope) we will see a crash as China and Xi probably understand these risks. Trump has not tweeted about stocks in a while and he might just get it too—though we have a tougher time with that belief.
There are several other issues complicating the market risk factors like BREXIT and the Italian budget, but we expect those to not provide a systemic catalyst like US-Chia trade could. Make no mistake, if those two go bad in the coming weeks (Dec 12 BREXIT vote in UK parliament), it could add to a snowball effect should the G20 meetings between Trump and Xi not bear any fruit.
So the question you need to ask yourself this week is am I ready for this and if it happens can I take advantage of it and not panic? In past crash type markets, they are always a buy opportunity. The crash is typically the bottom capitulation. My guess is that we could see a 5-10% gap down if Trump and Xi do not show progress. If Trump says they are going ahead with 25% tariffs on Jan 1, the market has a good chance of a mini crash.
Say you are a typical 60% equity 40% bond investor. I would look to be closer to 40% equity, 60% bond going into this event risk. If the worst-caser scenario plays out, use the gap down to go back to your longer-term target. If it does not, you will still participate in the market rally that likely happens in the case where they shake hands and agree to find a solution. That is the most likely outcome.
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