- The stock market has been taking a historic pounding over the past few days.
- In part, you can blame the fact that inflation, a force virtually unseen since the financial crisis, has reappeared on planet Earth.
- It’s changing economic conditions and making the world a riskier, more volatile place for Wall Street.
If you’re concerned about the Dow falling an ominous 666 points on Friday amid other economic indicators looking sound, or you’re worried because on Monday it tumbled more than 1,100 points in its biggest-ever point drop, you can remain calm. The market is just experiencing regime change.
That is to say, the specific economic conditions in which we now find ourselves have changed the market as the world has known it for almost a decade. The winds have changed, and Wall Street is getting to know its new master. It’s a painful process.
Now, in one word, the culprit for all of this is inflation.
For the first time since the financial crisis, it has begun to reappear on the face of the earth in a meaningful way. One would think that the prospect of its reemergence after years of waiting would be cause for celebration – but again, against our current economic backdrop, it’s cause for caution.
This is the stew we’re working with here:
- A weak dollar (inflationary).
- An incredibly tight labour market (pushing wages up – so, inflationary).
- Tax cuts, and the borrowing we’ll do to pay for them (inflationary and inflationary).
- The threat of a trade/currency war (inflationary/inflationary).
- A paralysed Congress (WILD CARD, BABY!).
Some of these elements, like rising wages, occur naturally in a growing economy like the US’s. And others, like our new tax cuts and the debt we’ll have to issue to pay for them, are man-made.
And then there’s the weak dollar, which is both.
Dollar weakness is a factor of a peak in its economic cycle, as well as an administration that can’t stop talking it down. We’ve got a lot of moving parts here.
But put all of them together, and this market is starting to look like an ice-skating rink covered with a thin layer of olive oil. For even the most experienced figure skater, it’s going be difficult not to lose control and fall.
Messing with gravity
For years we’ve known that this moment – whenever we got to it – was going to be a delicate one. How could it not be? What we are experiencing right now is the economic equivalent of watching the laws of gravity change.
At the moment, the entire world is in the process of reversing years of unprecedented, coordinated, low-interest-rate policy. No one was 100% certain what it would all look like while it was happening, let alone what the world would look like when we were done.
What we did know then (and do know now) is that when the gravitational pull changes, money will begin to flow around the world at different speeds and in different directions, headed to destinations unknown.
Adjusting to the world’s new money flows comes with a measure of uncertainty. When rates start to rise because of a tightening labour market and rising wages, how can anyone be sure when they will stop, especially when there are other inflationary elements at work in the economy? Will the Federal Reserve have to respond with rate hikes? If so, how many?
This is regime change.
Across Wall Street, volatility models are busting, and technicals are changing, and strategies are being thrown out as the entire plumbing of the global economy is being reconstructed. For traders, this means the buttons on the machine that is the stock market don’t do what they used to. Everything must be relearned.
On a grander scale, no one knows how other governments will respond to these new inflationary conditions. Take, for example, dollar weakness – or what Joachim Fels, the global economic adviser at Pimco, is already calling a “cold currency war,” in which the US tries to keep its currency low and the rest of the world races lower to stay in step.
Shahab Jalinoos, a trading strategist at Credit Suisse, warned clients that this could lead to continued erosion of one of the most important sources of global economic stability: trust.
“If the ‘rule of law’ for FX markets is now being breached by a key player” – the US – “to the point that other ones complain in public, the odds rise of a more chaotic environment characterised by far less cooperation, even if we avoid outright ‘currency wars,'” Jalinoos said.
Risk has changed, and the market is responding. The result is that now what Wall Street sees when it looks at this market is an incredibly dry forest going into what could be a particularly dangerous wildfire season.
Playing with fire
Now add to this calculation the fact that Donald Trump is the president of this dry forest and that he happens to enjoy playing with matches. He will only add to volatility and uncertainty.
What exactly does that look like? Allow me to illustrate using remarks he made at a Customs and Border Protection roundtable on Friday, where the president was discussing countries that refuse to take back their citizens once they have been removed from the United States.
Here’s what he said (emphasis added):
“So if they don’t take them back and – you know, those are unusual names, because you think in terms of South America more so than you do Asia. But if they don’t take them back, we’ll put sanctions on the countries. We’ll put tariffs on the countries. They will take them back so fast your head will spin. We’ll just tariff their goods coming in, and they will take them back in two seconds. You have a lot of people from those countries, and they will take them back.”
We should note that one of the worst offenders in this case is China, a country that could do significant damage to the US in a trade war. Every country is not, in fact, the same.
Of course, Trump isn’t the only domestic political source of potential instability in a more skittish market. He’s a symptom of a deeper problem that ratings agencies have been warning about since 2011: the divide between political parties.
This first came up during the nasty debate over whether to raise the debt ceiling and maintain the world’s full faith in the credit of United States of America.
When we almost wavered back, markets puked, and Standard and Poor’s lowered the country’s credit rating to AA+ from AAA.Here was its rationale:
“We lowered our long-term rating on the US because we believe that the prolonged controversy over raising the statutory debt ceiling and the related fiscal policy debate indicate that further near-term progress containing the growth in public spending, especially on entitlements, or on reaching an agreement on raising revenues is less likely than we previously assumed and will remain a contentious and fitful process …
“The political brinkmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed.”
This situation has only gotten worse. We lurch from fiscal crisis to fiscal crisis, worsened by a lack of leadership from the White House. This week, we face the prospect of yet another government shutdown because Congress can’t pass a budget. This never makes markets happy.
What’s worse, if we pass another temporary measure to keep the government running and kick the budget-making can down the road, we could potentially be trying to cobble together a budget while also debating whether to raise the debt ceiling. Very fitting.
There will be prayers sent up from all over Manhattan, but the market is unlikely to simply turn around and go back to being the sleepy, always-rallying creature it used to be. The world has changed materially, so the market is changing with it. That will be a more treacherous environment for some who navigate it, but others will be more suited to it.
As they like to say on Wall Street when they’re feeling especially macabre, “adapt or die.”
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