The Specter of Knightian Uncertainties

As is the case with nearly all equity market strategists, I usually look at markets through the lens of quantifiable knowledge -corporate earnings, economic data and modeling, and historical trends. Normally, that process yields highly predictive and correlated results. What would typically be considered constructive catalysts for an equity market rally over the past several weeks and months have all failed to produce any meaningful follow through—quite the opposite has been the case.

The calendar alone should historically argue for a modest rally into year-end, but that certainly has not materialized yet, nor does it appear to be in the offing. Further, the mid-term election results provided no lift for equity prices, nor did Chairman Powell’s effort to walk back his hawkish tone in interest rates recently. Reliable economic data, a better-than-expected earnings season, indications that a trade conflict truce between the United States and China have all also failed to ignite investor enthusiasm. My insistence on a constructive outlook for equity markets for Q4, based on traditional metrics of measure, has not panned out.

What gives?

Increasingly, it appears as though institutional investors are more inclined to manage the risk associated with an approaching cycle-end than they are remaining long the market. That theme was given a degree of confirmation this past week when the 2-year to 5-year inverted. Traditionally, an inverted yield curve is considered a forward-looking indicator of a recession. Additionally, confusion and uncertainty over the extreme dysfunction in Washington have begun to wear on markets. The ongoing Mueller investigation and associated drips and drabs of news releases have undermined what has increasingly become fragile investor confidence.

Additionally, concerns over global growth have increasingly spoken to slowing growth and near geopolitical chaos in the case of the European continent.

France is in the throes of violent riots that could mutate into a revolution and bring down President Macron—yesterday’s European Man of Destiny. Germany is suffering a leadership crisis brought on by Merkel’s reckless decision to invite the Middle East into the continent. Italy is engaged in a bitter struggle between its populist government and the increasingly autocratic European Commission over an economic policy that has repressed Italy’s growth for 20 years. Hungary and Poland are also at odds with Brussels. And half the continent is dragged down by the weight of a falling Euro.National Review

Increasingly, it appears as though British Prime Minister Teresa May will fail in her efforts to marshal enough support in the House of Commons to have the Brexit agreement between the UK and EU passed. That is undoubtedly adding to the uncertainty that is being priced into markets – not just here in the United States, but globally. To add to that euro-centric concern, France’s head of State, Marcon’s approval ratings have fallen to 18% – a record low in modern French history. The ongoing violent protests in the streets of Paris and elsewhere in France since mid-November has continued to escalate. Many had initially pointed to the latest increase in fuel taxes as the primary driver of discontent, but increasingly it appears as though there is a great deal more to this ongoing state of protestation than simply a fuel tax. Nearly every political faction in France is participating in the upheaval. The violence in the streets of Paris and elsewhere are the worst they have been in over fifty years, and further, nearly 70% of the French population supports the protestors. Italy’s budget is also a factor for investors. The coalition government of Italy has effectively let the EU know that it would not be adhering to the fiscal lines drawn by the ECB. The war of words that has begun between EU officials and the ECB and the Italian government has sharply escalated. There is no blueprint for how it will all be resolved.

No sooner had President Trump announced a breakthrough in trade conversations with China’s Xi Jinping than the CFO of China’s largest mobile phone manufacturer (Huawei), Meng Wanzhou, and daughter of its founder was arrested in Canada at the request of the FBI – unbeknownst to the White House, according to some news accounts. The timing of the arrest had an immediate and negative impact on markets – not to mention geopolitics. Cynics quickly suggested the move by the FBI was meant to undermine the President’s effort on trade.

With all of those themes forming a rather dramatic backdrop, investors have to ask themselves the question: Are we at the precipice of a bear market, or are we witnessing a correction within our long-running bull market?

All indications are that our economy continues to expand at a sustainable pace. Last Friday’s release of the November Employment Report was where investors were hoping it would land – positive job growth, but less robust than consensus. For the month the US economy gained 155k jobs, manufacturing payrolls grew by 27k, and the unemployment rate remained at cycle lows – 3.7%. Consumer Confidence remains robust. The December reading was 97.5 – matching November’s reading. The EIA Petroleum Status Report for the previous week saw a draw on crude oil inventories of 7.3m bbl. The ISM Mfg. Index for November was a stronger-than-expected 59.3. These are not data points that speak to a slowing economy.

Knightian uncertainty may pull markets lower yet – effectively triggering a meaningful and sustained economic slowdown and equity market bear sooner rather than later. My sense, as I have outlined in previous notes, is that we do tip into a mild recession in the first half of 2020, but that doesn’t mean there aren’t opportunities for a slowdown sooner. This week will be a significant test for equity markets. Given last week’s drubbing and revisit to recent lows, the momentum is lower. A meaningful break lower by US equities, given the technical weakness with which we closed out last week, could well deliver a negative performance in the year.

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Flickr photo: Colin_K