Reason to be skeptical of the latest central bank reflation trade
The title of this piece refers to an old cautionary Wall Street cliche that describes a trader’s dilemma where the price action says one thing but his gut warns him that something is not quite right, and to not get too complacent. This is an apt description of the current state of play over the past few days. Markets are reacting optimistically to a potential trade deal with China and the prospect of supportive policy intervention by the major central banks, most of which involves creating more debt. Besides possible rate cuts by the Fed, BOJ, and ECB, China unleashed another huge credit impulse, see https://bit.ly/2kAGnTz, South Korea has enacted a massive fiscal spending program, see https://on.ft.com/2ZBihGx and the Germans are exploring ways to circumvent current limits on debt issuance, see https://reut.rs/2kDcsKl. That’s a lot of stimuli. No wonder the markets like it.
However, this collective panic among the policy crowd in the face of slowing economic growth doesn’t offer any new ideas other than to throw more money at a situation that previous waves of cash have failed to fix. Most investors now realize that after a decade of extreme monetary policies, excessive debt is becoming the problem, not the answer. It’s the reason why large parts of the world are trapped in a deflationary malaise. Not only will piling on more debt not work, but it will also make the eventual reckoning even more painful.
Since early this year we have focused on several trends: slowing global growth, falling rates, and a stronger dollar. A continuation of these generally-bearish themes, along with the pressure that it exerts on the vulnerable corporate credit and emerging market sectors, is still our base scenario.
Nevertheless stocks, yields, credit, and commodities have all caught a bid in recent days. The dollar is offered. With good reason, investors still strongly believe that the central banks can affect outcomes and that a safety net is firmly in place under the markets. One of our favorite risk sentiment canaries, the Canadian dollar, impressively held support at USDCAD 1.3400 (see chart below.) This is a sign that a broader recovery in the marketplace in the near-term is not only possible but likely.
Longer-term, the prospect of a global economy that is weakened by over-indebtedness and unable to maintain sustainable growth without the repeated intervention of central banks is a frightening prospect, and remains our primary concern. The big danger in our future will come at that point when investors lose faith in central bankers’ ability to keep the markets propped up. We’re not there yet but that re-set in valuations will be the trade of a lifetime…and not in a good way. Will it be next month, or next year, or five years from now? Nobody knows. So in the meantime enjoy this latest bull party but remember to dance near the door.