Stocks – in the eye of the storm

It's hard to reconcile stability in US stock markets given gathering sings of a storm. The S&P 500 is still up 13% on the year, NDX 15.8% and China A-shares 16.7%. At the same time the Fed-funds futures are pricing in almost a certainty of a Fed rate cut  by December, and a good chance of more.

This tranquility comes amid material changes in global  political landscape. One can dismiss the EU parliamentary elections last week as a  protest vote with the results "less bad" than expected.  But the losses of centrist statist parties to the fringes, be it on the right or left, are impressive. The British two-party system took a mortal blow with Conservatives taking 9% of the vote and Labor 14%. The political continuity in Germany looks shaky, Macron's party  lost to Le Pen, and Italy looks set to get a Lega  government this year.  The impact of the elections will entrench the sense of unease, prolong the Brexit uncertainty and remove any possibility if European economy pulling its weight anytime soon.

There is no longer a path to  roll-back the US-China trade war. China hasn't retaliated sparing US tech firms. But the lack of retaliation is not a sign of giving in, just a cold cost-benefit analysis as retaliation hurts US less.  China announced measures to decouple from western supplies in telecoms infrastructure. The besieged Huawei is rolling out a replacement for Android operating system.  The narrative from mainland news media and pundits is that the US consumers will pay the lion share of the tariffs and the loss of market share in the US is acceptable. President Xi is preparing the public for prolonged tensions and hardship.  In the absence of Chinese concessions, tariffs will go higher again at the end of June damping business sentiment across the globe.

There is also an issue of the US elections in 2020. Prediction markets and most forecasts favor a democratic president and house. Trump could potentially squeeze through, but only if the economy is doing well. That creates a negative feedback loop for the market – the worse the economy does the more ominous the election looms.

What does it mean for the stock market? The most logical explanation is it will expect the Fed to ease quickly as US economic data sag. The QE playbook will be dusted out as well if rates would need to go to the zero bound.  After all ECB hasn't been able to lift rates once since Greece, and the German 10y yields are once again negative.  Japan has resigned to zero interest rates for 10y bonds for the foreseeable future. The experience of the last 10 years was that the stock market in the US keeps moving up without large drawdowns helped by policy support when needed.

However, it seems implausible that all such stimulus will happen while the stock market is only muddling through. We are in the eye of the storm, and it can only get worse before it gets better.