"Do you not know, my son, with how little wisdom the world is governed?"                                 

  -Axel Oxenstierna, Lord High Chancellor of Sweden 1612-1654

If you want an answer to the question, “why has the stock market been swinging so wildly up and down?” The answer is the title to this article – Trump, Interest Rates and China. It’s certainly been an interesting month and a half or so in the markets. The overall downward moves really haven’t been all that significant by historic standards. Ten percent corrections happen about once per year on average and at its nadir so far this year the markets haven’t dipped very far below that figure. It’s been the volatility that’s been unusual. This whipsaw (to use JP Morgan CEO Jamie Dimon’s term) of 2-3% swings in both directions on a day by day basis is not totally unprecedented – but far more rare than a regular ten percent correction. So let’s look at the reasons for these big swings and why they are not in and of themselves causes for concern.

The Federal Reserve has been raising interest rates over the last few years, while at the same time selling off some of the bonds it purchased during the financial crisis. Up to a point these interest rate increases have been warranted, the economy is growing at a reasonable pace, unemployment has fallen to a historic low (although it can be argued that the current 3.7% rate is closer to the 5 – 6% rate from twenty years ago – a subject for another time) and inflation was starting to creep back up. After years running sometimes less than 1%, for the first half of 2018 inflation ran at 2.5% and in the first four months of the year appeared to be accelerating. Higher rates are great for investors and savers; finally you could find 2 – 4% interest rates on very safe, sometimes principal guaranteed investments. Interest rates are almost starting to feel normal for lack of a better term. You might even earn enough interest on your checking and savings accounts for a few pennies to actually show up on a statement. But there are signals all around that rates really shouldn’t be raised any more. Those inflation rates that came close to hitting 3% a couple of months during the first half of the year seem to be slowing back down to the low 2’s again. The spread between the rates of long term bonds, which are controlled more by supply and demand in the economy, and short term bonds, which are controlled far more by the Fed, have significantly tightened to the point where at this writing the rate on a two year bond is higher than the rate on a five year bond. An “inverse” yield curve where short term rates are higher than long term rates has been a very good predictor of coming recession. Now in this case only the five year was lower than the two year – the recession indicator is when the ten year bond yield is lower than the two year; also this inversion needs to happen for a reasonable period of time, a few days can just be a blip that doesn’t mean anything and so far neither of those conditions has been met. One of the reasons this indicator seems so good a predicting recession is that an inverse yield curve typically means the Fed has raised rates too far and the Fed itself may be what caused these recessions; they are getting pretty close to that level. When Fed Chairman Jerome Powell spoke a few weeks ago and indicated the interest rate increases may be nearing an end, interpreted by the experts as either only one more rate increase in December followed by a pause, or maybe one more increase at the January meeting as well then a pause, the stock market rallied with the Dow rising more than 600 points. The specifics of one or two increases over the next two months don’t matter as much as what the markets have indicated in general, both the stock market in its reaction to Powell’s statements and the bonds markets in raising the ten year rate at a slower pace than the Fed is raising the shorter term rates. The markets are telling us that the Fed needs to slow down the interest rate increases because economic growth and inflation rates are not high enough to warrant anymore at this time. So we’ll see what happens. If I had to guess I would say the Fed raises rates in December – since that is so expected the impact is probably already baked in to the markets – and then takes a break. So just as an aside, if you have money you want to have principal protected but have been hesitant to invest it since you were counting on those fixed interest rates getting better, just as they have over the whole year, now is probably your chance. With the most recent sell-offs rates have actually dropped a little on CD’s and fixed annuities compared to where they were a week or so ago, so you are probably safe locking yourself into something for a couple of years as this round of increases is likely close to finished.

In the summer of 1813, the combined Armies of Russia, Prussia, Great Britain, Sweden, Spain and Portugal finally beat Napoleon on the field in a series of battles. Withdrawing back into France with a depleted army and surrounded on all sides by the Troops of the “Sixth Coalition” the French Parliament forced Napoleon to abdicate and after some negotiations go into exile on the island of Elba off the coast of Italy. The Napoleonic Wars were over and Europe was finally at peace. That is until Napoleon showed back up in France, within three months had raised an Army of almost 200,000 and vowed to win back the French Empire. Similarly the U.S. vs. China trade war seemed to be over. During the G-20 summit, unbelievably only two weeks ago, President Trump and President Xi agreed to a tariff ceasefire and a doubling down on trade negotiations between the two countries. While there was some small sniper fire for the next few days as the Trump administration and the Chinese government released slightly different versions of what was agreed to, all and all it seemed like at least a pause in hostilities. The tariffs were sent off to a cozy villa in Elba to live out the rest of their days. Then on Tuesday, December 4 Trump sent out a tweet calling himself Tariff Man –the most boring of all superheroes. Then over the course of December 5 when the markets were closed for the National Day of Mourning for President George H.W. Bush, the Canadian Government arrested the CFO of Huawei, a Chinese Tech giant – the Chinese Apple if you will. The immediate reaction to this arrest was confusion, you usually don’t take hostages in a trade war, but as the day went on and more information came out it became clear there was evidence of real crimes being committed by Meng Wanzhou, the aforementioned CFO – but not before the markets dropped almost 3% before rallying back up (the catalyst for the rally being Chairman Powell talking about stopping rate increases, just to bring that around again.) The indication once again is that the details and news stories can be misleading and cause the markets to over-react, but in general the markets are telling us a trade war with China will fundamentally hurt the economy.

So let’s explore this U.S. China relationship a little more and see why nobody really knows what’s going to happen. I had a little back and forth with Brad McMillian, the CIO of Commonwealth over the last few weeks about this and I’m not going to print our email exchange verbatim because that’s unfair to Brad and would probably not be compliance approvable for the general public – but I can give you the gist of it. China gets more financial benefits from trade with the U.S. than the U.S. gets out of trade with China – that’s just a fact. Approximately 5% of China’s GDP is in direct trade with the United States, but since many products China manufactures are components for other things, like say car parts that get shipped to Japan to go into Toyotas and then those Toyotas get sold in the U.S. the impact is probably higher. Imports from China only amount to about 2% of U.S. GDP and it’s easier to replace a supplier from China with a supplier from Indonesia, or Bangladesh or Vietnam than it is to replace a buyer like the United States, the biggest economy in the world, that imports more than Germany, Japan and Great Britain put together. So on balance a trade war will hurt the Chinese more than it will hurt the United States. Brad seems to think this fact will drive China to the negotiating table before things get out of hand with the tariffs, and in fact that may be the whole point of the tariffs, simply to get negotiations going like happened with the recently revamped deal between the U.S., Canada and Mexico. I have been reading other sources however, that tell a slightly different story. They agree that China will suffer more economically than the U.S. from a prolonged trade war, but they argue that China can bear more pain than we can for a longer period of time. Unlike Mexico and Canada with democratically elected governments, China doesn’t have to worry about a tariff induced recession throwing Xi and the rest of the ruling party out of office. Trump and the GOP controlled Senate don’t have that luxury, if a trade war causes the U.S. to drop into a recession – especially if that recession is at a deep point in the second half of 2020 – they may not retain power long enough to see the trade war through. China can’t go into economic doldrums for years and years on end either – Social unrest can happen in even the most controlled societies once the food starts to run out – but China has enough cash reserves and borrowing power to keep things seemingly good through a couple U.S. election cycles. I didn’t disagree with Brad’s side in our exchange, I was playing devil’s advocate; but for every piece of evidence he has for the “China will blink” argument other sources that I respect have evidence for the “China will wait for us to blink” argument. Maybe cooler heads will prevail and nobody will have to blink we’ll just get an agreement that cuts down the middle, it’s anybody’s guess.

As these issues are tossed around, and until there is some resolution in at least one of them, the markets will continue to ricochet back and forth. If the ultimate direction from those bounces is up, it’s really not a problem – if it continues to be down then we could be in for some more unpleasant investment statements in 2019. Either way, we position our client’s assets with the understanding that the day to day and even year by year movements in the markets are unknowable and frequently volatile. Any money you might need next month or even next year is positioned in investments that are not subject to the volatility of the stock markets – or even the intermediate bond markets. It’s that long-term money that is typically still in volatile assets, and while the day to day swings can be worrisome, the long-term upward trend of the markets has always been the best way to accumulate wealth over more substantial lengths of time. 

So as another year ends I want to thank all of our current clients for your continued trust in Keeling Financial. For those of you who read this newsletter who are not yet clients of ours, make that New Year’s resolution to get your financial house in order and give us a call. A late Happy Hanukkah, a Merry Christmas and a Happy New Year to you all.