Known Unknowns

March 1, 2018

When you think about the number of meaningful changes with imprecise consequences, it’s no wonder that world financial markets are more volatile in 2018 and why investors remain very jittery.

Four of the changes involve U.S. economic policies. The earliest to be undertaken was broad government deregulation including but not limited to the activities of financial institutions. Cutting red tape can free up animal spirits and lift baseline economic growth. It’s also important to realize that regulations are protective insurance to limit damage from extreme case scenarios that hurt many people. Reduced financial market deregulation in the decades prior to 2007 was a cause of the Great Recession.

The second U.S. policy change is the broad yet complicated tax cut. Tax cuts create immediate extra disposable income, but the allocation of that extra spending power is skewed heavily to a segment of the population that has a comparatively low propensity to consume. The biggest cut was made to corporate income taxes, with a prediction such will stimulate investment in plant and equipment and the creation of jobs. It was also predicted that lower corporate taxes would boost profits and therefore share prices. The fragility of stocks in recent weeks underscores how unpredictable are the results of a tax overhaul as sweeping as the current one, which among other things has rekindled worries about the soaring budget deficit.

Any change in Fed leadership concerns investors. Each new leader has to earn the market’s trust, and that doesn’t happen quickly. There was great uneasiness when Paul Volcker stepped down in 1987. Alan Greenspan had been long rumored to be the front-runner to replace him and already had a good reputation on Wall Street, yet markets reacted adversely at first when the announcement was officially made. To build anti-inflationary credibility, Greenspan wasted little time before raising interest rates. Markets were put on edge, and the crash of 1987 on October 19th happened just ten weeks into his stewardship.

Jay Powell also comes to the job with a favorable reputation, but the choice of him is unorthodox in some respects. Fed Chairs since 1970 had graduate training in economics with the sole exception of G. William Miller, a businessman, and that experiment was widely considered a huge bust. Also, the decision to replace a Fed chair at a time when the economy is performing well and after just a single term flies in the face of the axiom  that if it ain’t broke, don’t fix it. Beyond Powell, Trump has other opportunities to change the composition of the FOMC coming up. More change means more uncertainty.

The fourth U.S. policy change kicked into a higher gear this week. Although President Trump campaigned on a protectionist commercial policy agenda, only now has that priority moved to center-stage, and it’s scaring the heck out of a lot of folks who know something about history and economic theory. A strategy of big import tariffs to protect key sectors generally leads to weaker growth, higher inflation, and a faster climb in interest rates.

In the background, markets are still carefully watching other U.S. developments and holding their breath. How will relations with China, Japan and Korea develop now that euphoria inspired by the Winter Olympics has passed? What dangerous turn might the Middle East take as the U.S. hastily moves its Israeli embassy to Jerusalem? How many more climate surprises will be disregarded? What’s the future timetable on the Mueller investigation? Where do the Me too and gun control movements go from here? Investors  sense that event risk has greatly risen but are left with little more than that reality when handicapping this bag of known unknowns.

And the stretch of this metaphorical black hole is not limited to the United States. An immediate matter is the Italian election next Sunday, which has the potential to explode the cohesion of the European Monetary System, if not the European Union. Xi Jinping has consolidated absolute power in China, and speculation is growing that it’s only a matter of time before China and the United States go at it militarily. Can Russia’s cybernetic assault on western democracies be stopped without the cooperation of the U.S. President. Does blackmail lie behind Trump’s inattention to this threat?

In past crises like the World Trade Center attacks and the aforementioned 22.6% single-day drop of the DOW in October 1987, the dollar reacted adversely. The subprime debt crisis in 2007, which surfaced in the summer of 2007, weakened the dollar much more against the yen than European currencies. Chairman Powell doesn’t seem worried that gradually rising interest rates might kill the economic expansion even if share prices continue to drop. U.S. economic fundamentals seem fine, and forward-looking indicators aren’t ringing any alarms. If the crash of 1987 wasn’t followed by a recession, why worry now?

Here’s a problem with complacency. Sometimes, a single big shock can overwhelm the economy and produce a downturn. Other times, recessions result from a confluence of many small stresses, none of which alone would threaten positive growth. Taken together, however, a critical mass develops to take down economic growth. The 2001 downturn was an example of the latter. As one looks around now, many problems not limited to those mentioned in this update can be observed. Stock markets are forward-looking. After a surprisingly long run-up in share prices to values that appear excessive when put in historical perspective, the downward correction already achieved in stocks is being taken in stride. With nine years gone since the last bear market, I suspect pundits will soon be predicting that we may already be in the next one, and even that would at first likely be divorced from forecasts of a coming recession. But on the heels of the highly touted tax bill, wouldn’t that be ironic, and in an election year no less?

Copyright 2018, Larry Greenberg. All rights reserved. No secondary distribution without express permission.




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