The three-day sell-off in U.S. stocks, which has wiped nearly 2 percent off the value of the S&P 500 Index, is a timely reminder to investors that they need to temper a bias toward short-term optimism with the recognition of unusual uncertainties stemming from the global system. It also raises interesting questions as to the best tactical response to what I believe will be increased volatility leading up to the 2020 elections, if not beyond.
The recent sharp sell-off comes after a significant rally in stocks in which all three major indexes registered one record after another, powered most recently by monthly gains in November of 3% to almost 5%. The rally was fueled by four main factors:
• A de-escalation of trade tensions between China and the U.S.
• Partial high-frequency indicators suggesting that the global economic slowdown may be bottoming out.
• Resumption of significant liquidity injections by the world’s two most powerful central banks, the Federal Reserve and the European Central Bank.
• Favorable market technicals due, essentially, to what has been one of the most unloved large and prolonged rallies in market history.
The sell-off was, interestingly enough, caused by a reversal of the first two factors. How deep it goes, along with the tactical investment implications, will be influenced by the strength of the latter two.
The re-escalation of trade tension is an almost inevitable consequence of the increased political weaponization of economic tools in response not just to economic and domestic political objectives but also in some cases to national security and human rights issues. Aggravated by the long-standing nature of genuine grievances, it is a process that will not go away soon. Indeed, as I have argued before, the periodic de-escalation in trade tensions should be treated more as a truce or cease-fire and not as a solid building block for a durable resolution.
The weaker-than-expected U.S. manufacturing data that came out on Monday pointed to an outright contraction in the sector. Its magnitude was large enough to raise immediate worries about possible adverse spillovers for the economy’s stronger and more dominant service sector. It also served as a vivid reminder of the depth of the global downturn in manufacturing caused by a combination of factors that will be hard to reverse anytime soon: uncertainties about the international trade regime; disruptions to some of the large and more traditional segments caused by technological innovations, such as gasoline-powered vehicles; slower market expansion in emerging economies; and the continued headwinds to actual and potential growth in many advanced countries.
With these factors constituting large clouds over the global economy well into 2020, if not beyond, a quick resumption in the stock rally depends crucially on strong market confidence in the strength of the other two factors — that is, the continued commitment, willingness and ability of central banks to support asset prices through balance sheet operations and lower interest rates; and the potential for money that has remained on the sideline to enter the market. This also speaks to tactical portfolio responses to the most recent decline.
With time, I have become less confident about both factors, though not enough to dismiss them entirely.
I have repeatedly argued that prolonged, ever-deeper and sole reliance on unconventional monetary measures risks turning central banks from being part of the solution to becoming an added problem. It’s a risk that is already flashing red in the case of the ECB, where negative yields are slowly but consistently eating away at the longer-term dynamism of the European economy, the integrity of the financial system and its overall stability.
Having said that, I doubt that, when push comes to shove, central banks will resist the temptation to do more in a classic case of what behavioral scientists label “active inertia.” It is also just a matter of time until markets press for more lax financial conditions. But such a policy response by central banks will continue to prove less effective in promoting economic growth and, if they are not careful, could shift from boosting asset prices to stoking market volatility that could spill over and damage real economic activity.