Beginning December 26th, the US and global equity markets rallied sharply through the end of January with the S&P 500 rising over 13%. The major components of the positive market narrative that drove the sentiment sprung forth from three themes: Fed policy pausing, China trade negotiations improving, and US government reopening. I believe this positive market narrative is about to stall and potentially reverse.
Takeaways for US business:
- Higher risk and uncertainty on the economy, interest rates and equities
- Trump administration and regulatory uncertainty
- Employee and client focus draining from core purpose
The major cause: the anticipation and release of the Mueller investigation.
As the Chief Market Intelligence Officer for the CFTC, my job was to objectively research and report on the market narrative driving prices in the risk transfer or derivatives markets. By market narrative, I’m referring to what Nobel Prize winner Robert Shiller referred to as the economic narrative: “By narrative economics I mean the study of the spread and dynamics of popular narratives, the stories, particularly those of human interest and emotion, and how these change through time, to understand economic fluctuations.” To accomplish this mission, I participated in weekly calls with other US agencies to discuss the facts, key market structures and issues, and the narratives surrounding them.
Looking back over 2017/2018, the powerful equity market rally was based on a gentle unwind of Fed easy monetary policy, a significant cut in the US corporate tax rate, and an economic stimulating fiscal policy. This drove the narrative of a strong economy with improving earnings and a Federal Reserve not moving quickly to take away the low-interest-rate-party punchbowl.
With the exception of one big hiccup on 2/5/2018, this narrative consistently provided an upward trajectory for the equity markets until December. Then, the narrative suddenly shifted from positive to negative with worries about Fed policy raising rates while releasing assets from balance sheet (QT), the large amount of US Treasury issuance putting upward pressure on interest rates, slower US and global economic growth, growing tensions on US-China trade, and finally, the US government shutdown. However, we’ve now shifted hard to a positive narrative for the reasons stated in the first paragraph. The mercurial nature of these markets should worry both business and investors alike as I believe we are about to shift again.
For business, these sudden shifts in narratives translate into risk and uncertainty over the cost of capital as interest rates and equity prices fluctuate rapidly. This shows up in CEO surveys and CAPEX surveys, which are already showing a softening.
Additional uncertainty arises because the Mueller investigation into Russian interference into the 2016 US presidential election and potential collusion with the Trump campaign appears to be coming to an end. News coverage is increasing, and many reports suggest a release by mid-February or sooner. Several questions arise that are potentially narrative shifting:
- Will Mueller seek a criminal indictment of President Trump?
- Will Mueller seek criminal indictments of President Trump’s family?
- If yes to 1 & 2, will President Trump issue pardons to himself and his family?
- If yes to 1, 2 & 3, will the US House begin hearings and vote to impeach?
- If yes to 1, 2,3 & 4, will the US Senate vote to convict?
While most of these will occur over time, the report release and indictments will not. Perhaps the biggest insight into the upcoming Mueller report is the fact that the Speaker of the House, Nancy Pelosi, is not allowing for a State of the Union (SOTU) address despite the re-opening of the US government.
While this may appear to be merely politics, there are a few reasons why the Speaker may not allow a SOTU. Number one, she expects the Mueller report to have an obstruction of justice charge against President Trump. Number two, she wants to begin holding impeachment hearings without giving the President the SOTU forum to address the American people to explain his side of the story. Number three, Speaker Pelosi expects Democrats to control the US House of Representatives for a long time and is not concerned that Republicans will withhold a SOTU for a Democrat President. Love her or hate her, Speaker Pelosi is a skilled politician; skilled enough to become speaker again and skilled enough to win the US government shutdown fight.
Unlike metrics regarding earnings and cost of capital, politics is factor many leave out in their analysis of overall market direction. Yet, it is a critical component of the market narrative driving values. For example, if an impeachment process begins, Congress essentially will shut down many normal functions (similar to operations during a Supreme Court nominee process). Legislation on immigration, healthcare, or trade agreements will either stop or slow to a crawl. Regulatory changes, approval for new products or mergers will likely slow or stop. Finally with all of the above happening, it will be challenging for managers and employees to remain focused on their work given the upheaval in the US political world.
Of course, the outcome of the Mueller report on its own won’t be enough to kill the recent rally in the equity markets. But, timing matters. We have a Fed meeting that may be more hawkish than anticipated, a China-US trade meeting that may not produce an agreement, and another potential US government shutdown in 3 weeks. Market narratives are not built with one story, but multiple stories all pointing in the same direction. We’ll need all of them, and maybe more to build something with enough power to shift the markets.
In this volatile environment, we should expect short-term rapid shifts in market sentiment triggered by political developments. To be sure, we’ll need to have multiple negative stories combine to create momentum for a longer, broader move lower. The Mueller report is likely the start.