A Convergence of Risks

July continued to see rallies in most global markets. The S&P 500 gained 1.44% and the MSCI World Index gained 0.53% in the month. The STOXX Europe 600 ended the month up 0.34% in Euro returns. Both the Euro and British Pound dropped sharply in the month as the region continues to struggle economically and is weighed down by an increased likelihood of a hard Brexit.

Most of the interesting action occurred late into July so I’m going to deviate from the usual script of discussing past events and delve into the current state and the month ahead as it is far more interesting and may be more relevant. The following material events occurred late in July and early into August.

1. The Federal Reserve cut interest rates for the first time since 2008.
2. Trump implemented a 10% increase in tariffs on certain Chinese goods.
3. China weakened its currency peg to the US; the yuan sank below 7 per dollar.
4. Increased likelihood of a hard Brexit under Britain’s new Prime Minister, Boris Johnson.
5. Iran escalates geopolitical uncertainty as it stops more oil tankers in the region

The Fed Cut Rates

Federal Reserve Chair Jerome Powell held a press conference on 7/31/19 announcing rate cut of 25 basis points (0.25%). This is the first rate cut since year end 2008. This was designed to offset “downside risks from weak global growth and trade policy uncertainty, to help offset the effects these factors are currently having on the economy, and to promote a faster return of inflation to… our 2% objective.” They also decided to conclude the run off of the securities portfolio (quantitative tightening) in August rather than September.

This had a material effect on the Treasury yield curve, which shifted downwards sharply towards the end of the month. The yield curve isn’t showing the stated rate on the bond, rather it shows what you would effectively get if you bought the bond today. The distinction is important because a 2.25% bond would get you 2.25% if you bought it at par ($100) and assuming rates would never change. If you paid more for it, your effective yield would be less. The downward shift indicates that yields are dropping and/or people are willing to pay more for the same bond than they were in the past.

Trump Escalates the Trade War

President Trump has been quite vocal about his unhappiness that the Federal Reserve raised interest rates last year. From the Federal Reserves’ perspective, the move was rational. The tax cuts were a form of fiscal stimulus at a point where the economy was rather healthy. Jerome Powell had concerns that the loose monetary policy was already creating a bond bubble, and wanted to ensure that we don’t encourage excessive risk taking.

Setting aside the optics of having a strong economy heading into an election year, the President has been trying to push back against perceived, perhaps justifiably, mercantilist practices from China. He believes that the best way to achieve that goal is by applying pressure via tariffs. I believe the tax cuts were meant to offset the effects of the domestic impact of the tariffs while the trade war was ongoing. This may explain, in part, why the US economy has held up relatively well despite the macroeconomic pressures seen in the rest of the world.

That brings us to the current state of affairs and game theory at play in the dynamic between the Federal Reserve and the President. If you recall from the prior section, the Federal Reserve is cutting rates (in part) due to “trade policy uncertainty.” Once we saw the Federal Reserve cut rates, the President took the opportunity to escalate the trade policy. It sets up an interesting dynamic where perceived weakness in the US economy could become a self-fulfilling prophecy as Federal Reserve cuts provide more ammunition to increase pressures on China.

China Weakens their Currency

Let’s knock out a few items first so we are all on the same page. China has a currency called the Renminbi (RMB), the name translates to the “people’s currency.” The RMB has been pegged to the US Dollar since 1994. The practice involves holding dollars in reserve to ensure the outstanding cash is worth a fixed amount relative to the dollar. A number of countries, including Bermuda, engage in this practice. It provides the adopting country with a stable currency but they give up the ability to engage in monetary autonomy, as the Federal Reserve controls monetary policy for the benefit of the US (which may be in a different phase of the economic cycle than the adopting country). Unlike Bermuda, China doesn’t peg to the US on a 1:1 basis. Instead, the People’s Bank of China (the Chinese central bank) determines the rate. This affords the country with some leeway to enact their own monetary policy.

On August 5th, markets fell as China weakened its daily currency fixing. The yuan devalued to over 7 RMB per dollar. There have been claims that China is manipulating its currency for competitive advantage on exports. China flatly denies these claims, and I am inclined to believe them. China is experiencing a slowdown in economic growth, largely due to the trade war and a slowdown in their European trade partners (for example, Huawei does far more trade in Europe than in the US). When currencies devalue, it makes their exports cheaper and their imports more expensive. Now you might be thinking, China is weakening their currency which helps their exports so they are therefore engaging in that practice to goose their exports. While that is technically true, they are not trying to engage in an unfair practice, rather, they are trying to prop up a weakening economy.

Britain has a New Prime Minister

The remaining members of the British conservative party elected Boris Johnson the new Prime Minister. Mr. Johnson has been one of the faces of the Brexit movement. His election increases the likelihood of a hard exit from the European Union. Since his election on 07/23/2019, the British pound dropped -2.65%.

As a reminder, this would result in Britain and the EU defaulting to the World Trade Organization (WTO) baseline tariffs. Mr. Johnson is trying to negotiate for better terms with the EU. As the October 31st exit looms, it seems unlikely the EU will budge from the terms they spent 3 years negotiating. Mr. Johnson’s initial attempt to renegotiate the Irish backstop appear to have ended in failure. The backstop would ensure an open border between Northern Ireland and the Republic of Ireland. The absence of physical boundaries in Ireland was instrumental in deescalating and ensuring peace after “The Troubles.”

Sadly, the best option for Britain may be to pull off the band aid and go into a hard exit as the uncertainty has prevented the nation from taking steps towards construction and is causing sustained pain as businesses cannot plan for the future. We appear to be looking at more pain in the short run.

A Belligerent Iran

First, some context. President Obama helped negotiate a multilateral agreement with Iran and Europe. The agreement created a pathway for normalized relations between Iran and the rest of the western world in return for a delayed nuclear program. President Trump did not believe the terms were in the favor of long run US interests so he backed out, something he technically couldn’t legally do within the framework of the agreement. The US then proceeded to place pressure on European companies to limit economic support for Iran. European partners tried to negotiate terms with Iran to keep them engaged in the process.

As Iranian oil exports ground to a near halt and the country fell into a recession, Iran has resorted to exerting its regional influence in the Strait of Hormuz (e.g., attacked/detained tankers and downing a US drone). While the anger at the US’ actions is rational, the steadily increasing aggression in the region does not appear to have a specific endgame that benefits Iran. The geopolitical uncertainty has caused a 19.68% rally in oil from June lows. However, the long-term trend has resumed and half the gains were given up by the back half of July.

From what I can tell, the US does not have the appetite for another war. However, part of the US and UK naval fleets have been relocated to the Middle East to ensure the protection of the targeted merchant vessels.

Conclusion

The LOM Balanced Fund has some discretion over asset class allocation. We were fortunate enough to have replaced some of our equity exposure with cash or lower risk asset classes prior to the 5-6% correction. While we still remain slightly overweight in equities, we are very close to the overall strategic allocation and have effectively locked in some of the gains near all-time highs.

Given the recent correction, I find the contrarian in me asking whether this is a good time to increase risk. The reality is none of us have a crystal ball. The sharp corrections (~3% losses in the US major indices) we’ve seen today seem to indicate a degree of panic that may not be justified. That could suggest the opportunity for a short-term recovery. However, I will continue to beat the drum on this being late cycle and the risks inherent in technology sectors (which the US indices are primarily comprised of) tend to be higher.

The information contained in this article is for information purposes only, and represent the views of the author. It is not intended as specific investment or financial advice, or a recommendation or solicitation to buy or sell any security. Any investments or strategies listed in this article may not be suitable for all investors. Past performance is not indicative of future performance, and as with any investment, prices may fluctuate. It is recommended that advice is sought from a qualified investment professional prior to implementing any financial plan. LOM has made every effort to ensure that the contents herein have been compiled from sources believed reliable, however LOM does not warrant the accuracy, adequacy, timeliness, or completeness of this information expressly disclaims liability for errors or omissions in this information.