Let’s start with a perhaps less obvious question:
Why 60 days?
Because that will take us through the historically volatile months of September and October (when fear can beget fear) to the middle of November, which historically tends to mark a turn in the markets toward an end of the year rally.
Because over these 60 days we’re looking at some “scheduled” events that could well drive this stage of the market–the September 26 meeting of the Federal Reserve (and another likely interest rate increase), the next stages in the U.S.-China tariff war with tariffs on a projected total of $460 billion in Chinese goods, the November 4 deadline set by the United States for its allied to join in on new sanctions on Iran, and an election that could shift power in Washington with unsettling effects.
Set against those potential developments over the next 60 days, I think we’ve got constants that include continued strength in the U.S. dollar and continued weakness in emerging markets, continued strength in the U.S. economy (although probably not GDP growth as strong as in the second quarter), better than solid growth in earnings for the third quarter (which could be, according to some estimates slightly higher than earnings growth in the second quarter) and the likelihood that inflation will keep moving, slowly, higher.
Putting all these elements together is a challenge but here’s what I think the next 60 days are likely to bring:
Continued weakness in emerging markets because of the strong dollar and because of fears that the Trump administration’s tariff policies are going to slow global growth. Emerging markets have been on the edge of a full-fledged 20% bear market recently. My rule of thumb, though, is that due to the greater volatility of these markets, they don’t enter corrections or bear markets at the standard level that developed markets do (that is 10% for corrections and 20% for bear markets.) I think emerging markets have further to slip over the next 60 days before they enter a true emerging markets bear market and start to look cheap enough to enough traders and investors so that they are willing to put money into these assets in spite of the risks. How much further down? I’m looking for a bottom somewhere around a total drop in emerging markets of 30% or so. That’s another 10 percentage points from here.
Relative outperformance of U.S. markets–with lots of volatility, though. The troubles in emerging markets (and the uncertainties in Europe) will keep cash flows headed in the direction of U.S. assets. We’ll get the same effect from rising interest rates and a stronger dollar. Plus projections from Wall Street analysts for 21.5% earnings growth in the third quarter will keep money in U.S. stocks through the October earnings season. If we get the normal 2 to 3 percentage point bump to actual earnings from projected earnings, earnings for this quarter will come in just slightly below the bumper growth of 25.9% for the second quarter. Nobody will want to walk away from that kind of earnings growth rate–especially because the second and third quarter look to be the peak in earnings growth for this cycle (thanks to the December 2017 tax cuts.) Earnings growth in the fourth quarter is now projected to drop back to a still very strong 18.6%. My best estimate is that we could see the Standard & Poor’s climb another 5% by the end of this 60 day period. Which would push that index over 3000 to a new historic high.
But that gain for U.S. stocks won’t come without impressive volatility. Sources? Fear that the emerging market crisis will spread from emerging to developed markets. We’ve already seen that. Fear that U.S. tariff moves will indeed take a bite out of U.S. growth. Fear that the Federal Reserve will once again put an end to an economic recovery. Fear of the usual suspect among geopolitical events: war in the Korean peninsula or in the Middle East, for example. Fear that U.S. stocks have to sell off (fear of fear itself.) I don’t think we’re looking at some extended market break but I would be very surprised if we don’t see a spike in the VIX (the CBOE S&P 500 Volatility Index) fear to 22 or 23 (which isn’t especially high by historical standards) or a plunge back to a VIX of 10 or so. (The VIX dropped 6.64% today to 13.22.)
In this environment some traditional risk hedges, such as the Japanese yen, should do reasonably well. Others, such as gold, will continue to lag. A strong dollar and rising interest rates even with slowly climbing inflation just isn’t a good environment for gold. I’d expect oil prices to climb modestly as worries over the November 4 deadline for U.S. sanctions and continued bottlenecks in U.S. production out of the Permian Basin. But supply seems abundant enough and growth in the global economy iffy enough to keep West Texas Intermediate below $75 a barrel in this period and Brent at less than $85–absent a shooting event in the Persian Gulf. (West Texas Intermediate closed at $69.84 a barrel today and Brent at $79.37.)
Can’t do a best estimate scenario like this without a list of wildcards, of course.
The biggest of those in the next 60 days is China and the U.S.-China trade war. To me it doesn’t look like China is about to fold on the tariff war. I think restricting the influence of overseas companies in China’s economy accomplishes enough of Beijing’s policy goals (as I wrote yesterday, September 10) to keep China from making the kind of major policy concessions that the Trump administration is looking for. I could be wrong–and a big settlement of the trade war issue would mean a big bump to global financial markets.
China gets a second mention on my list of wildcards. It looks like economic growth in China is slowing enough so that the People’s Bank and the government could sell announce stimulus efforts within this 60 day period. In the short run such an announcement would lead to a bounce in emerging market assets–more growth in China means more sales of emerging market goods and commodities to China. But over a slightly longer run any stimulus, especially any stimulus which overtly weakened the Chinese yuan, would lead to more selling in emerging markets as emerging market currencies felt more pressure and as investors and traders worried about the effects of cheaper Chinese goods competing with emerging market products.
Investors and traders have to keep in mind, too, the possibility that the November 4 deadline for new U.S. sanctions could lead to some event that might destabilize global oil markets. So far the consensus among economists is that slightly higher oil prices aren’t going to take very much away from global growth. But a spike in the price of oil would be a different question entirely.
And finally there’s the possibility that the Fed with new and relatively untested leadership might say something to raise fears that the U.S. central bank will more aggressively raise interest rates in 2019 than the markets now anticipate. Market participants are very aware that the Fed has a track record of killing economic expansions with interest rate increases that are intended to head off inflation. The assumption, I think, in the markets is that Fed will do it again in this cycle–that indeed the U.S. central bank has to if it is to bring monetary policy back to something like neutral and reduce the size of its balance sheet. But markets would like to see that happen later rather than sooner.
If you look out more than 60 days there are plenty of reasons to worry about the continued longevity of this bull market and this economic boom. There is the worry that I just mentioned about the Fed. There’s the huge debt overhang created during the boom and that has in recent years added a considerable amount of questionable–and dollar denominated–debt to corporate balance sheets in overseas markets. We are very late in the credit cycle and it isn’t hard to argue that we’re headed to a Minsky Moment of reckoning sometime in the next three years or so.
That’s the back ground for the next 60 days–and it explains much of the nervousness and volatility of this market. But I don’t think we’re about to see a day of reckoning quite yet.