Fri, 22 Nov 2019

More than anything else, last week's market gyrations illustrated the tug of war that has dominated US stocks in recent months and confined them in a range despite significant developments in the underlying dynamics. The intensifying tension between the two macro forces could lead to greater volatility and pose increasing challenges for investors.

The first part of the week was dominated by investor concern that international weakness in manufacturing had spread to the US and, more importantly, to the services sector, which dominates the domestic economy. The result was a harrowing two-day drop in stocks that erased the gains of the previous five months.

The second part was much different. Hopes for support from Washington, fueled by constructive comments from the White House about the coming trade negotiations with China, were accompanied by the release on Friday of the September jobs report, which kept the door open for another Federal Reserve rate cut this month. Stocks rebounded, significantly cutting into the losses for the week.

This roller coaster is not new and exemplifies the interaction between two big macro themes, or what economists call "global factors." The intensifying tug of war, however, raises questions about the stability of this "unstable equilibrium" for markets and the consequences for investment strategies.

As the week demonstrated, the long-standing risk of downward pressure on stocks from weaker fundamentals has been amplified recently by mounting evidence that US manufacturing is now part of a global contraction caused by a deepening slowdown in international trade.

Adding to the gloom, data on sentiment suggests that this is already spilling over to the much larger services sector. And while solid readings from more comprehensive hard data releases, such as the jobs report, didn't ring additional alarm bells, it wasn't strong enough to establish that the US economy is immune to pressure from the rest of the world.

On the other side of the tug of war, the policy hopes that have pulled stocks higher have shifted from central bank action to trade and other measures. This is not because investors have concluded that the Fed is unlikely to cut interest rates this year - it most likely will - but because they realize the cuts probably won't materially improve the economic outlook. Recognition is spreading among market participants that there is an important difference between a friendly central bank and an effective one. Moreover, in the case of the European Central Bank, such prolonged friendliness risks being counter-productive beyond a certain point.

Consequently, the optimists now center their hopes on the possibility of a US-China trade deal and fiscal stimulus in Europe led by Germany.

Some feel that with US President Donald Trump now facing possible impeachment, his administration will be more inclined to reach agreement with China - a partial deal - even if it falls short of the comprehensive and durable outcome for which many are hoping.

The coming visit of a Chinese trade delegation offers optimists a timeline for their hopes. Meanwhile, weakness in German economic data is seen by these optimists as the catalyst for significant fiscal stimulus.

The growing strain between these two global factors increases the uncertainty for the worldwide economy and markets and threatens the "unstable equilibrium" that has persisted until now.

For investors, the situation challenges the sufficiency of the traditional approaches to diversifying holdings and mitigating risk. It increases the risk of unsettling volatility, multiple equilibria and the threats of mistakes that come with that.

In such a world, investors should consider, at the minimum, adding an element of "regret minimisation" to their portfolios. This means strongly emphasising balance-sheet strength and other quality considerations in selecting stocks, building a bigger-than-usual cash buffer in their asset allocation and shortening maturities on their corporate and government bonds.

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