Forget Government Shutdown, The Fed And China Are The Only Things That Matter To Investors Right Now
What will crash the market again this month? It’s not President Trump and Nancy Pelosi in their made-for-TV tug of war over government funding. BlackRock knows what it is: If it’s not the Fed, it will be flawed China trade talks this week and market fears of a semi-hard landing there. The Fed and China are the biggest things on Wall Street’s mind.
Judging by investor reactions again on Monday, the market seems convinced that Fed chairman Jerome Powell has taken a cue from his accommodative predecessors Janet Yellen and Ben Bernanke. There will be no rate hikes, at least not in the first quarter.
The upbeat tone on Fed policy, however, may be short-lived. Be warned: Barclays and BNP Paribas both sent out a note to clients almost immediately after Powell, Yellen and Bernanke spoke at the American Economic Association in Atlanta on Friday. The two investment banks think interest rates are going to 3% this year. The Fed hikes at least twice, despite weakening manufacturing data. Within the core economies, the U.S. is still the hottest game in town. Economic data is deteriorating, but it is falling from a very high level. The U.S. economy is also burning Europe and Japan, two regions working with zero-interest rates.
Of course, everybody knows Powell can blow up the gains made in the last 48 hours when the Fed releases its meeting minutes tomorrow. His Fed has a penchant for pulling the rug out from under the U.S. stock market, and with it, much of the equity indexes worldwide.
“Median rate expectations for 2019 dropped to two hikes from three … in line with our base case,” says Richard Turnill, global chief investment strategist for BlackRock. The result: a softer growth outlook for the U.S. Turnill says that Wednesday’s meeting minutes could provide clues to the Fed’s future path. He doubts a rate hike in March. Wednesday’s meeting minutes are from the previous meeting. The next Open Markets Committee meeting is scheduled for January 29 and will be a tone setter for the rest of the quarter. The U.S. economy is approaching its late-cycle growth spurt. Fed policy could tip the scales in favor of the bears.Investors will be laser-focused on economic data for clues about the health of the global economy as well, even if Powell seems less mindful of it. Both Germany and China stock markets are in bear territory.
After U.S. interest rates, another key issue is China trade and the Chinese economy overall. What will become of trade talks between Beijing and U.S. negotiators on Tuesday? No one is expecting major progress, but nothing bad can come from this today or China stocks will drop even further. China underperformed the S&P 500 and the MSCI Emerging Markets Index yesterday.
Since the global financial crisis, China has served as a significant amplifier of Fed policy. Recent moves by the People’s Bank of China show that the world.s No. 2 economy is becoming more reliant on easy credit conditions to avoid the dreaded hard landing the China bears have been warning about for years. Until China’s credit bubble bursts, the interplay between the Fed and China is bullish for risky assets.
Why bullish? Because “The Fed can’t get overly tight or China is going to blow up,” says Brian McCarthy, founder of Macrolens, an investment research firm in Stamford, Connecticut. “For the market, it’s not going to be ‘Oh the Fed is too tight, so it’s just going to be a slower economy.’ No. That’s not the read. The read will be that it’s going to create a supernova in China.”
Any Fed error in interest rates threatens China’s credit bubble or forces the central bank to weaken the yuan. Financial markets will interpret that as a blow to China and a headwind for emerging markets just starting to attract investment again. Xi Jinping does not want China to continue expanding on credit because he knows that provincial governments tend to use credit to invest in unsustainable projects and businesses. On one hand, this is good news because it gives Beijing a reason to end the trade war. The trade war is not helping a China already in slow motion, with Xi trying to clean up the country’s debt burdens. On the other hand, it pressures Xi to give up on his pledge to rein in bad loans and oversupply, including in the all-important housing market where second- and third-tier cities like Yantai are littered with vacant real estate.
“The Chinese credit bubble is like an electric fence keeping the Fed from getting too tight,” says McCarthy. “The Apple profit shock last week perhaps provided a little jolt.”
Government shutdown has been a nonissue
Worth noting, the Apple profit shock came after market hours on Wednesday, sending all indexes down on Thursday. Then Powell spoke with Yellen and Bernanke and the market recovered. It was a moment of China taketh, Fed giveth.
Data points are not looking as good as they used to, though that does not mean a recession is coming. U.S. manufacturing activity fell to a two-year low last month, according to the Institute for Supply Management. And China’s factory activity shrank for the first time in over two years.
Regarding the government shutdown, which to date has been a non-issue for markets, Barclays Capital economist Mike Gapen estimates a 0.1 percentage point reduction in U.S. GDP for every week the Federal government remains closed. President Trump said the government could remain closed “for a long time, perhaps a year.” The market rose anyway.
This article originally appeared in Forbes.