Paradigm shifts tend to happen slowly, and then all at once. That’s the lesson I’ve taken away from the recent market turmoil. As I wrote last week, the surprise is only that the upset didn’t come sooner.
Pundits may have pegged the worst Dow drop of the year to fresh bond yield curve inversions in the US (a historic predictor of downturns) but the underlying signs of sickness in the global economy have been with us for a long time. The question was when the markets were going to put aside the complacency bred by a decade of low interest rates and central bank money dumps, in the form of quantitative easing, and embrace this new reality.
Consider that since January 2018 every major economy except India’s has seen a deterioration in its purchasing managers’ indices. PMIs are one of the best forward-looking indicators of economic conditions for the manufacturing sector, which is a bellwether for overall economic activity. The slowdown in the eurozone has been dramatic — particularly in places such as Italy and Germany, where the economy is now officially shrinking.
As strategist Louis-Vincent Gave of Gavekal pointed out in an investor note, the “fingerprints of many culprits can be detected” in the manufacturing sector’s troubles, from an automobile sector facing structural challenges, to the Boeing 737 Max fiasco and its effect on global supply chains, to the lack of any big new product launches in the technology sector, to lacklustre corporate investment, a weak energy sector and a slowdown in China. All that is required is one big sovereign default or a cascade of corporate bankruptcies and we could see the market in free fall.
Politics, of course, hasn’t helped. But again, none of the recent developments have been very surprising. Take Argentina, which suffered a 48 per cent one-day market drop last week after its presidential primary election saw the Peronist opposition comfortably ahead. The question is why investors were, as the old Casablanca line goes, “shocked, shocked!” to find that a country that has been a serial defaulter would swing back to the left.
This raises other questions. What might happen in the UK if a general election, before or after a no-deal Brexit, allows Jeremy Corbyn to take power? What might the future of Italy’s turbulent politics hold? What could be the impact of an Elizabeth Warren or Bernie Sanders victory in the US primaries? As a recent 13D Global Strategy
and Research note put it, such events would “fit perfectly into the cyclefrom wealth accumulation to wealth distribution”, which I believe will be the biggest economic shift of our lifetimes.
Why is this new reality taking so long to sink in? Because we have spent decades of living in the old reality — the post-Bretton Woods, neoliberal one. Unfettered economic globalisation and years of easy monetary policy have buoyed asset prices and favoured capital over labour, seemingly indefinitely. Our senses have been numbed by trillions of dollars released by central banks, by algorithmic trading programs that buy on the dip and thus diminish the sense of long-term political risk, and by record passive investing.
All this has combined to dampen the signals that are now, finally, blinking red. Witness the recent downturn in bank, transport, and industrial indices, as well as the fall in small-cap stocks, a historic predictor of trouble in bigger companies. At the end of a recovery cycle, capital tends to crowd into large companies and smaller firms suffer.
As the markets finally come to terms with increased political risk, currency risk, credit risk, and the growing likelihood of leftwing governments, it’s clear that the shifts and the shocks are coming fast and furious. No wonder that everyone is now left asking, “What comes next?”
The answer, I believe, is very likely to be a synchronised global recession, punctuated by a step-by-step market downturn — one in which there may be the odd rally, but the general direction is down. This could last for some years. In the next few weeks, I would expect new lows in bond yields, a deepening of the yield curve inversion, higher prices for “safety” assets like the yen and swiss franc, and a continued bull market in gold.
I would also expect more tough talk from Donald Trump. The US president’s persistent bashing of China and the Federal Reserve will follow any market downturn. There will probably be more attempts by Mr Trump to wrongfoot the opposition, such as the decision to delay new tariffs on Chinese goods until December so that consumers won’t be hurt during the Christmas shopping season. (None of this makes a real trade deal more likely.)
Meanwhile, American consumers are already hurting and that could have big implications for Mr Trump’s 2020 re-election campaign. Momentum in job growth in swing states such as Michigan, Ohio and Pennsylvania is slowing.
One recent report conducted by liberal pollster Stan Greenberg showed that a third of working-class white women in some conservative areas are starting to turn against the president, irritated by his frequent boasts about the booming US economy. “Maybe in New York City,” said one woman from Wisconsin. “But not here.”
For Mr Trump, and the US public at large, the summer of fear may turn into a winter of political discontent.