By Alan Bush | Senior Financial Economist at ADMIS | Modern Trader Magazine
It was late February 2018 when the opening salvos of a burgeoning trade war were fired as President Donald Trump announced plans to impose a 25% tariff on all steel imports and 10% on all aluminum imports. But it wasn’t until April when those plans began to take form. President Trump ordered tariffs on steel and aluminum imports and, pending a public comment period, planned tariffs on still more products from China (see “Trade war heats up,” below).
The $50 billion in tariffs on Chinese imports was in retaliation for what he called decades of intellectual property abuses. As a result, there were sharp declines in stock index futures.
China responded with tariffs of its own and threatened more to come when China’s ambassador to Washington said China will take countermeasures of the “same proportion” and scale if the United States imposes additional tariffs on Chinese products. China quickly hit back with a list of similar duties of up to 25% on U.S. imports, including soybeans, pork, beef, recycled aluminum, steel pipes, fruit, wine, planes, automobiles and chemicals. Many economists now see a risk that the world is headed toward an all-out trade war and one that the World Trade Organization (WTO) may not be equipped to manage.
From when the recession lows for stock index futures were made on March 9, 2009, there have been a variety of geopolitical events that have temporarily interrupted the price advance. The key word is temporary because every time traders and analysts have become too focused on the geopolitical risk-off event of the day, equity markets have been rescued by central bank accommodation. The recoveries were often swift with new highs not far behind.
In fact, since the lows were made more than nine years ago, there have been a multitude of geopolitical issues that temporarily pressured stock index futures. Many of them appeared insurmountable at the time, with little hope of being resolved any time soon, and were feared to have catastrophic consequences for the stock market and the global economy (see “Recovery busting scares,” below). In the early stages of the bull market for stock index futures there were times that these negatives came in faster than some central banks could ease credit conditions, including the European Central Bank, the People’s Bank of China and the Bank of Japan; and faster than the Federal Reserve and the Bank of England could talk back their hawkish rhetoric.
These scares included the following examples.
European Debt Crises: The European sovereign debt crisis was a multi-year series of problems that started in 2009 when the world first realized Greece could default on its debt. In three years, it escalated into the potential for sovereign debt defaults from Portugal, Italy, Ireland and Spain (also known as PIIGS). The Eurozone debt crisis was the world‘s greatest threat in 2011, according to the Organization for Economic Cooperation and Development, and resulted in the largest correction in equity markets during the current recovery — more than 20%. However, equities rebounded relatively quickly and took out the May 2011 highs the following February.
Annexation of Crimea by Russia: The Crimean peninsula was annexed from Ukraine by the Russian Federation in early 2014. Ukraine and many world leaders condemned the annexation and considered it to be a violation of international law. This was followed up by incursions into Ukraine by Russian troops without insignia, which heightened tensions between Russia and the West. Still, the market basically sloughed this off.
Crude Oil Price Collapse: Many analysts saw the drop in crude oil prices as a precursor to a period of poor performance in global stock markets. Crude oil and equity market prices often fall in tandem, as was the case during the financial crisis of 2008-2009. Equity markets saw a pair of 10% corrections in late 2015 and early 2016 as crude oil dropped below $60 per barrel. This has arguably been the second weakest performance period for equities during this recovery.
China Economic Slowdown: In early 2016, there were fears of a severe slowdown in China’s economy, which is the world’s second largest. Chinese economic growth slowed markedly and the country’s central bank expected growth in 2015 to have been the slowest in a quarter of a century. After growing 7.3% in 2014, the economy was thought to have expanded by 6.9% in 2015. In addition, the central bank forecast that it may slow further in 2018 to 6.8%.
Global equity markets nosedived on China’s economic woes with one trader saying the markets were “bordering on the edge of panic.”
Brexit: In the aftermath of the U.K. vote to exit the European Union, the Dow Jones Industrial Average futures were predicting that the gauge would open down nearly 650 points. Prior to the vote, the polls were predicting the U.K. would remain, so it was quite a surprise when the leave vote prevailed. There were widespread predictions that the pro-Brexit vote would not just derail the British economy, but could be disastrous to the global economy as well. The market reacted negatively to the vote, but quickly recovered.
China Currency Devaluations: There was pressure on stock index futures and the world faced deflation shocks when China devalued the yuan at an accelerating pace. Exporting deflation from China to the rest of the world was thought to have potentially disastrous consequences. Equities dropped for a period along with crude, but rebounded as the market has with the rest of the post-recovery crises.
Tensions on the Korean Peninsula: Rising tensions between the United States and North Korea brought a wave of falling stock prices, as worried investors moved funds out of equities and into safe-haven vehicles such as U.S. Treasuries and precious metals.
Political Turmoil in Washington: A cascade of controversies in Washington politics spilled over with a focus on the 2016 presidential election. Hillary Clinton was the assumed frontrunner and represented the status quo. Donald Trump was the wild card that threatened a potential trade war and greater uncertainty. This threat came to fruition on the night of the election and the market discounted it all in one day. The market has been mostly oblivious to subsequent controversies.
New Highs after Every Geopolitical Risk since 2009: Every time stock index futures fell due to the bearish geopolitical influences in the last nine years the break was short-lived, as prices recovered and ultimately made new highs.
In hindsight, there was no need to be overly concerned about the adverse market impact of the multiple European debt crises, the Ukraine conflict and Russian sanctions, the oil market collapse, China’s economic slowdown fears, China’s currency devaluation, the Brexit vote, ongoing tensions on the Korean peninsula or ramped-up political turmoil in Washington.
And now we have the global trade issues. The current trade situation has the potential to have a greater effect on stock index futures than the other geopolitical events that took place during the past nine years, but only if it gets out of hand. And the market could be more vulnerable to topping out with many of the factors that drove a bullish consensus, such as the tax cut and regulatory relief priced into the market. However, the biggest bullish driver for equities, relatively low interest rates, remains.
It is extremely uncertain as to when the trade issues will get resolved. There is reason to believe that the trade war will probably drag on for a while, and in this politically dominated environment, it will be difficult for stock index futures to advance, particularly if a trade war escalates. However, there are already signs that the Trump Administration will not push matters too far, especially if they can appear tough and be able to claim a victory. It is safe to say the trade issues will eventually be “resolved” without a full-out trade war and once they are, the bullish interest rate fundamentals will take over, just as they have since early 2009.
The historically low global interest rate environment can be expected to once again rescue stock index futures. In spite of the steady interest rate hikes from the U.S. Federal Reserve — three quarter percent increases in 2017, with a total of three more anticipated in 2018 — U.S. interest rates are still historically low as the current Fed funds target is 1.50% to 1.75% (see “Fed funds, still a bargain,” left).
Remember that the Fed funds rate was as high as 20% in 1980 and averaged close to 10% the 1980s. European central banks in the late 1970s and early 1980s had correspondingly high interest rates as well.
Currently, the European Central Bank remains extremely accommodative as it continues to implement its asset purchase plan (quantitative easing). Analysts expect the central bank of the Eurozone to make a decision in June or July to possibly phase out its bond-buying program by December. The European Central Bank said in a statement that it would continue to buy €30 billion ($36.4 billion) a month of Eurozone bonds at least through September and will leave its key interest rate unchanged at -0.4%.
The Bank of England’s (BoE) key interest rate peaked at 17% in 1979. Currently, the BoE’s main interest rate stands at 50 basis points, which is the lowest it has been since the BoE was founded in 1694. Financial futures markets are predicting the central bank of the UK will not raise interest rates any time soon.
With some overseas interest rates remaining near or at historical lows — and in many countries interest rates are still negative — there is still plenty of accommodation left in the domestic and international banking systems.
Now we have the trade tensions between the United States and China that caused many analysts to declare that global economic growth will be stymied, which will result in a protracted decline in stock index futures. At least that was the consensus view on the initial news of the escalating trade tensions.
However, we are already seeing what appears to be a better tone to the U.S./China trade situation when senior officials at the State Council, which is China’s cabinet, said China is planning to lower tariffs on imported cars. An announcement was expected to be made as early as May.
It is fair to say that in the broad scheme of things there is never any more or any less risk of geopolitical threats in the world. There are only changes in perception and the amount of attention paid to the various risks, new and old, that have been with us since the beginning of time.
It will probably be the case that like all the other geopolitically motivated downdrafts in stock index futures during the past nine years, the current trade tensions will only be able to temporarily keep stock index futures under pressure before the bullish influence of the still historically low global interest rate influence dominates and takes stock index futures higher.
For more information about these markets, please contact Alan at 312.242.7911 or via email at email@example.com. Thank you.
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Futures and options trading involve significant risk of loss and may not be suitable for everyone. Therefore, carefully consider whether such trading is suitable for you in light of your financial condition. The risk of loss in trading futures and options can be substantial. The views and opinions expressed in this letter are those of the author and do not reflect the views of ADM Investor Services, Inc. or its staff. Research analyst does not currently maintain positions in the commodities specified within this report. The information provided is designed to assist in your analysis and evaluation of the futures and options markets. However, any decisions you may make to buy, sell or hold a futures or options position on such research are entirely your own and not in any way deemed to be endorsed by or attributed to ADMIS. Copyright © ADM Investor Services, Inc.
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