The big story for stock market bulls to latch on to this week has been the creation of NAFTA 2.0 as some are calling it.
But something else is going on that threatens to derail the good times – and send markets crashing. We’ll get to that later.
It’s Donald Trump’s shiny new trilateral trade agreement between the US and its neighbours, Canada and Mexico, that’s been causing all the excitement.
Trump’s New Deal
A couple of weeks ago, it looked like the deal was off, with only Mexico accepting Trump’s terms.
Canada’s spikey Prime Minister Trudeau was playing hard to get, refusing to agree to the suggested concessions…
Generally rubbing Trump up as he likes to do.
Cue more trade threats from Trump.
If Trudeau didn’t come in on the pact, the US would hit Canada harder – blocking imports of Canadian cars to the US, for example.
Fast forward two weeks, after long nights for the negotiators, and the United States-Mexico-Canada Agreement or U.S.M.C.A. is born.
“It’s not Nafta redone, it’s a brand-new deal,” Trump proclaimed.
And that’s given investors all they needed to launch the Dow Jones index to yet loftier all-time highs. It came to within spitting distance of 27,000 (before selling off rapidly…)
No doubt about it, Trump’s bullyboy tactics around the world are doing wonders for the markets.
Every little scrap of good news sends investors into a new buying frenzy.
But when it comes to world trade, USMCA is small time…
It’s all about China
The ongoing issue is what goes on between the US and China.
And so far, there’s no sign of any meaningful breakthrough in relations between the two.
If anything, things are getting worse, as the South China Morning Post reports:
“Last week the United States infuriated Beijing with a proposal to sell US$330 million worth of arms to Taiwan, and US President Donald Trump accused China of meddling in the US midterm elections. Washington has also sanctioned a Chinese defence ministry unit and its director for buying weapons from Russia. In response, China recalled its naval chief from a visit to the US.”
So, it’s no longer just a matter of economics and trade between the two superpowers…
It’s also about national security.
Did you see the news from the South China Sea last Sunday?
A US Navy destroyer came within metres of colliding with a Chinese ship that, according to American reports, was conducting “unsafe and unprofessional” manoeuvres.
China’s been trying for years to exert control over the whole of the South China Sea.
That’s causing tension between it and other countries in the area, such as the Philippines, Malaysia, Thailand and Vietnam. They all have competing claims for the territory.
It’s getting so busy in the area, it’s like Piccadilly Circus, as the international community steps into “push back against China’s claim” to the waters, according to the Economist:
“Earlier in the month Japan sent a submarine to conduct drills in the sea for the first time. In August a British warship was confronted there by Chinese ships and jets. And this month ships from Australia, Singapore, Malaysia, New Zealand and Britain will take part in more than two weeks of joint naval drills in the same crowded waters.”
We’d better hope there are no more serious incidents… or this could get seriously out of hand. To the extent that it’s not just the bubbling trade war that threatens the global economy… but a full-blown military conflict.
On the scale of things, that’s probably a bit of an ‘outlier’ in terms of events that threaten the world order and financial markets right now.
You kind of have to hope that both Washington and Beijing wouldn’t let it get to that…
Chalk that one up on the ‘Black Swan’ threat list…
A more likely threat is unfolding right now
What’s far more likely is that the stock market party’s going to come to an end due to something in plain sight…
Specifically, rising inflation which in turn triggers an acceleration in interest rates and brings down the whole house of cards that’s been built on cheap debt over the past decade.
Billionaire investor, Stanley Druckenmiller (one of George Soros’s old cohorts), is so concerned on that front that he believes we’re in for a financial crisis even worse than the one in 2008.
He told Business Insider last week that global low interest rates had “infected financial markets and led to exorbitant pockets of debt all around the world. More than anything, he’s worried about the reckoning that’s bound to transpire as global central banks make borrowing more expensive.”
As you know, it’s already underway.
In the US, the Federal Reserve has just raised rates for the third time this year and the eighth since it started tightening in 2015.
If all goes to Fed plans, they’ll be done raising rates by early 2020.
But that’s based on its assumption that it can keep a lid on inflation at an acceptable level…
If anything happens to cause an inflation spike – let’s say, for example, a rapidly rising oil price – then the Fed might have to drastically change its plans…
And start hiking rates even faster.
Stock market investors won’t like that at all.
Increasing borrowing costs hits businesses and consumers alike…
Companies cut back on borrowing and get charged more on existing debt. Consumers stop hammering their credit cards.
Both affect corporate profits and economic growth… and the thought of that filters through to negative stock market moves.
In short, rising oil prices could mean accelerating rate hikes.
And wouldn’t you know, that could be happening right now.
$250-oil to cause inflation shock
The price of a barrel of Brent Crude oil hit $86.64 yesterday.
That’s the highest price since November 2014. And US (WTI) is also at four-year highs.
The spike comes ahead of sanctions about to take effect on Iran’s oil exports, starting in 4th November.
In further evidence of Trump’s bullyish behaviour, he’s threatening sanctions on other countries that continue to buy Iran’s oil.
And it sounds like other countries are taking note…
“Over the last two weeks, there’s been a lot more evidence that even some of the larger customers – India and China – are not going to be buying Iranian crude from November,” said John Saucer at Mobius Risk Group. “These sanctions are likely to be a lot more effective than people even thought.”
That’s something speculators in the oil market have clearly picked up on, causing the latest move higher.
Reuters reports: “Oil traders have piled into wagers that U.S. crude oil could surge to $100 a barrel by next year, a milestone that until recently many considered unthinkable due to record U.S. production growth and relatively flat global demand.”
And it could go even higher, if things get ugly out in Iran.
We looked at this in Monkey Darts back in July – when we reported that Iran could escalate matters by choking off the world’s oil supply.
Tehran has threatened to blockade the crucial Strait of Hormuz, through which 20% of the world’s oil supplies must pass.
If that supply was disrupted, $100-oil could be a reality within days.
According to Nick Giambruno, an analyst at Casey Research, that could be just the start:
“I would expect the effect on the oil price to be at least as severe as the first oil shock in the 1970s. Back then, oil prices quadrupled. In today’s prices, that would mean oil shooting above $250 a barrel.”
Higher oil prices = higher interest rates
A substantial run-up in oil prices will feed through, not only to higher pump prices for fuel, but also transportation and utilities prices.
The question is whether the Fed’s current path of rate hikes is enough to keep that inflation in check… or whether they’ll need to raise their game.
Bond market investors – genuinely recognised as the smartest investors out there – look to be betting on the latter…
As well as rising oil prices, the latest Institute for Supply Management (ISM) data out yesterday showed that the U.S. services sector expanded last month at its fastest pace on record.
That led to a spike in treasury bond yields to the highest level in nearly two years, as traders offloaded bonds.
The prospect of rising inflation and interest rates makes the fixed yields on bonds less attractive.
So, if bond traders are selling, it means they’re betting that inflation will rise faster than the Fed expects… and that the Fed will have to be more aggressive.
So far, the Fed is comfortable with its current rate path.
Time will tell if it – or the bond markets – are correct.
All we know for now is that yesterday the Dow Jones sold off aggressively into the close as bond yields spiked.
Markets are twitchy to say the least. Professional investors see what’s going on in the bond market and they’re lightening up on stocks.
And according to Stanley Druckenmiller, they’re right to be worried.
“The crux of Druckenmiller’s argument is that, after a decade of easy lending, investors worldwide will be shaken to their core by tighter monetary conditions. Once the endless supply of cheap money that’s flooded global markets starts to dry up, all bets will be off, and a market collapse will be in order.
“With the monetary tightening, we’re kind of at that stage of the cycle where bombs are going off,” Druckenmiller said. “My assumption is one of these hikes — I don’t know which one — is going to trigger this thing.”
It’s not happened yet.
But watch out for tensions between the US, China and Iran… and where the oil price heads from here.
And don’t keep all your money tied up in stocks…
If inflation does kick off – and if the stock market collapses – ‘alternative’ assets such as gold and silver could come sharply back into favour.