June 25, 2019

I did not think we would see a fresh new high in the stock market before a trade deal with China was consummated. The moral here is to never underestimate the ability of the Twitter account of the U.S. President to create a short squeeze in stocks, particularly if the Federal Reserve has already more or less promised that a July fed funds rate cut is coming. The July 2020 fed funds futures, which will settle about a year from now, call for four 25 basis point rate cuts from the Fed (I calculate that from 100 minus the 98.58 price of the ZQN20 quote, which implies a mid-2020 fed funds rate of 1.42%).

If there is a trade deal with China, there may not be four fed fund rate cuts delivered as the U.S. economy very well may re-accelerate. There is a tendency for major tax cuts to have a second-leg effect, after the initial sugar highs blow over (that is already behind us). There is still too much doom and gloom in investor sentiment because of the Chinese trade situation, which is understandable, as a full-blown trade war can create a recession both here and in China. The doom and gloom investor attitudes have been supported by sharply weakening manufacturing indexes and other economic data in the U.S. of late.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

We are not yet in recession territory, but a 10-year low in U.S. Manufacturing PMIs is rather telling. This is why the 10-year Treasury traded below 2% in the past month. Still, the Chinese have not devalued the yuan (yet). We are not in a recession, yet we still saw the 10-year Treasury yield drop like a rock.

When the recession comes, and when (or if) the Chinese decide to devalue the yuan, the 10-year Treasury yield is likely headed below 1%, similar to what many government bond markets in Europe and Japan have delivered. This is due to the willingness of the Fed to go to extreme monetarist measures to support the economy and because European and Japanese negative yields are pulling Treasury yields lower.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

It has to be mentioned that in my conversations with investors, most think that the next recession will be very serious – a repetition of the Great Recession of 2008. I do not believe that will be the case. The 2008 recession was manufactured in its severity, as the global banking system nearly stopped working. While certain large European banks – like Deutsche Bank – have already taken out their 2008 stock market lows, it is unlikely that regulators, both here and in Europe, will let a Lehman-size institution fail. (For comparison purposes, Deutsche Bank’s balance sheet is 3X the size of Lehman’s at the time it failed.)

Furthermore, it is not the failure of Lehman Brothers that caused the 2008 Great Financial Crisis. Lehman was merely a catalyst, not a cause of the crash. The same decline in the stock market would have happened, but likely over a two-year period instead of one, because of improperly designed mortgage securities that were wiping out banks’ balance sheets and the shrinkage of available credit in the system.

Junk Bonds, Yet Again, Called the New Stock Market Highs

It is rather telling that if one were to compare the largest junk bond ETF by assets – the iShares IBoxx $High Yield Corporate Bond ETF (HYG) – and the largest stock ETF, the S&P 500 SPDR (SPY), one would see similar performance. (Using the SPY ETF instead for the SPX Index compares both investments on a total return basis, as SPY also includes dividends.)

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

What’s more telling is that junk bonds have been leading the stock market all year. They got taken down after the stock market started selling off in the fourth quarter of 2018. They bottomed out and made a fresh 52-week all-time high (on a total return basis) in 2019, leading up to the May 5 Tariff Tweet, which sent stocks temporarily down. About a week ago, they made fresh all-time highs before the S&P 500 did.

If the U.S. economy were that weak, junk bonds would not be that strong – the recent sharp downturn in manufacturing indexes notwithstanding. Could it be that junk bonds, and the stock market for that matter, are seeing through the soft patch and looking forward towards that second-leg effect of the major Trump tax cut? Yes, it sure could, but it would definitely help if we could get the Chinese trade deal out of the way.

That is, as they say, “a very big if,” because of the high likelihood of the Chinese not having negotiated in good faith before the infamous May 5th Tariff Tweet. A lot is riding on this week’s Trump-Xi meeting.

About The Author

Ivan Martchev

Ivan Martchev is an investment strategist with Navellier.  Previously, Ivan served as editorial director at InvestorPlace Media. Ivan was editor of Louis Rukeyser’s Mutual Funds and associate editor of Personal Finance. Ivan is also co-author of The Silk Road to Riches (Financial Times Press). The book provided analysis of geopolitical issues and investment strategy in natural resources and emerging markets with an emphasis on Asia. The book also correctly predicted the collapse in the U.S. real estate market, the rise of precious metals, and the resulting increased investor interest in emerging markets. Ivan’s commentaries have been published by MSNBC, The Motley Fool, MarketWatch, and others. All content of “Global Mail” represents the opinion of Ivan Martchev


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