Markets let off a little steam

Markets reduced immediate pressure last week, but pressures remain.

When I was a kid my Mom used a pressure cooker to make lamb curry among other delectable dishes. Pressure cookers are not that popular today because if the pressure valve on top gets clogged the thing explodes. Kind of like financial markets today.

Negative pressure has been building in financial markets and continues to build. However, last week the financial market pressure valve worked and let off a little steam, temporarily relieving some immediate market concerns:

1. The Hong Kong extradition treaty was finally killed by the HK government, yielding to the demonstrators' primary demand.

2. The US and China agreed to resume trade talks in October, and China offered to make US farm purchases as officials prepare for new talks.

3. Jobs data was not as bad as some had feared helping equity markets to rally and bonds to sell off a bit.

4. Fed Chairman Powell transmitted to markets another rate cut may be in the offing.

4. Technically, equity markets put in a decent performance, and were positive for the week.

However, markets remain volatile and choppy. Fundamentals continue to slowly deteriorate. Economic growth is still positive but slowing. FactSet estimates S&P500 earnings will grow at a meager 1.5% compared to January's estimate of 6%, a sharp reduction. The damage already done to the global economy due to the China situation is to some extent reflected in sharply lower bond yields, but equities have not yet gotten the memo. Equities often lag the bond market in discounting available negative information. (Stock jockeys are often overly optimistic compared to their dour fixed income counterparts.)

Further, I doubt killing the extradition treaty will solve the HK issue. I expect additional demonstrations, so markets should not be overly sanguine on this issue until there is a longer-term resolution to the problem.

For bi-lateral relations between China and the US, they may kiss and make up for show, but to quote an old B.B. King song: "The thrill is gone, it is gone for good." So, a small bounce was warranted given the parties will go back to the negotiating table, but it will be a short term bounce once the bitter reality sets in, or China reverses its policy of re-energizing its clunky state owned enterprises at the expense of private companies, something no one is calling for today.

So, if risk markets want to continue to rally, it is not because the earnings outlook is improving, or economic growth is accelerating. Nor is it because there is much value left in most risk markets. More likely, the problem continues to be that there are few attractive alternatives as interest rates plummet.

Alan Greenspan predicted this week that negative interest rates would spread to the US, meaning US growth will slow further and cause the US to follow Alice, Japan and Europe through the looking glass into the upside down world of negative interest rates.

So, some immediate areas of visible pressure have been relieved somewhat. The markets let off a little steam. Good. Some forecasters are even predicting new all-time highs which are not far away from current levels in some markets. But chasing richly priced markets like we have now leaves little room for error.

A small amount of obstruction in a pressure cooker causes it to blow up. Similarly, when interest rates are close to zero, debt levels high and asset valuations near all-time highs, some small event could spark a market sell-off. Not saying the blow-up is at hand, but conditions are lining up to the point that risk reduction is warranted. Pressure cooker blow-ups are not pretty, and neither are market blow-ups.

Pressure cooker blow-up.

The risk/reward for risk assets from here is not favorable. Better to keep some dry powder in say risk-less 3 month US Treasury Bills at a 2% yield, or even gold. For those seeking more return, uncorrelated alternative fixed income is one of the few places to safely pick up any yield and avoid a blow-up.

(Disclosure: I correctly forecast and made money in the 1987 stock market crash, the 1992 bond market debacle, the 1997 Asian Financial Crisis, the dot-com bust and the 2008 financial collapse. I have a pretty good nose for this stuff built into my DNA. Caveat, I am often early, so be patient, and stay tuned here to see which direction this will break and when.)

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