Halloween Haunts That Likely Won't Spook This Bull

Stocks gave investors a treat on Halloween, continuing a nascent (potential) rebound from Monday’s low. Only time will tell whether this is a false positive or the start of an actual recovery, but in the meantime, headlines offered a witches' brew of spooky stories. We saw China hard landing ghouls, tariff vampires, Italian debt poltergeists and rising interest rate bogeymen—basically, the same gaggle of spooky characters that makes the rounds whenever markets get rocky. In our view, the rehashing of old ghost stories is a good sign stocks’ lousy October is a short-term drop—painful but normal in bull markets—rather than the start of a deeper, longer, fundamentally driven bear market. To see why none of these spooks is an actual monster under markets’ bed, read on.

The Curse of the Chinese Slowdown

Yes, Chinese GDP growth slowed to 6.5% y/y in Q3, and October’s purchasing managers’ indexes hit a two-year low. The popular narrative holds that tariffs are biting the world’s second-largest economy, and its troubles will soon infect the rest of the world as demand sinks.

We think this ignores a few key factors. For one, China’s slowdown predates tariffs and seemingly stems more from regulators’ attempts to deal with excess in the shadow banking sector—off-balance sheet loans that many smaller companies rely on for funding. Reining in these lenders limited small businesses’ access to capital, hurting their ability to compete and expand. Regulators have long known they would need to find a way to crack down without inflicting heavy collateral damage on the economy. Recent stimulus announcements suggest they took slower monthly economic readings as a sign they needed to craft a bigger cushion, and as those stimulus measures take effect and work their way through the system, businesses ought to feel some relief.

As for tariffs, Chinese trade data remain plenty strong. Number crunchers have determined that the yuan’s recent weakening has largely offset the tariffs, enabling Chinese exporters to sell into America without jacking up prices or taking a big hit. In other words, the more things change, the more they stay the same.

The Great Tariff Haunting

Most of the aforementioned trade data cover a period when new tariffs applied to only about $100 billion of total US/Chinese trade. That figure swelled to $360 billion in late September, and the Trump administration has signaled it may slap taxes on all remaining Chinese imports early next year if their upcoming talks with Chinese President Xi Jinping and his officials don’t bear fruit. So while tariffs haven’t yet shown up much in broad trade data, many worry they will next year, putting the global economy at risk.

This still strikes us as a collective failure to properly scale the issue. Even if all threatened tariffs take effect—including all Chinese tariffs and levies on US auto imports—the likely tariff payments amount to less than 0.3% of global GDP, based on the IMF’s latest estimates. It wouldn’t be fun, but the powers that be could probably double or triple the tariff burden without sparking a global recession. Plus, firms are already getting creative at dodging tariffs. If North Korea can routinely dodge sanctions and get a shiny Rolls Royce for Kim Jong-un, US manufacturers can probably find a way to keep buying foreign steel without paying steep penalties. Or, exporters can simply find new buyers—as US soybean producers seem to have done, if a ship carrying 69,244 metric tons of soybeans changing its course from China to Vietnam last week is any indication.

The Case of the Chilling Italian Debt Bomb

Once upon a time, there was a populist government that wanted to cut taxes and raise spending on social services and infrastructure. But EU leadership didn’t want other populist pretenders to get any ideas, so they blocked these supposedly radical budget proposals. While the populists dug in, their country’s GDP growth flatlined and long-term interest rates rose, sparking fears of higher funding costs hamstringing private businesses, bringing recession and a debt crisis. That country is Italy, and this is the story many headlines are spouting this week.

We won’t argue budget uncertainty has no effect on Italy’s economy. Actually, businesses have a lot of incentive to play the waiting game right now, as it is difficult to execute a long-term plan when you don’t know what the future tax structure will be. Will the current progressive system remain? Or will the government get the EU’s blessing to enact its preferred modified flat tax, with just two low-ish rates, in hopes of juicing growth? We suspect simply knowing the answer to this and other questions would help release some pent-up demand, causing everyone to wonder what the fuss was about.

Meanwhile, our opinion of Italy’s finances and economy hasn’t changed. Debt service costs remain at generational lows. Although long rates are up somewhat lately, since Italy’s weighted-average debt maturity is just under seven years, long-term interest rates would likely have to shoot far higher and remain there for years before interest payments become problematic. As for funding, higher long-term interest rates helped steepen Italy’s yield curve, which should make banks more apt to lend. While higher long rates could theoretically hurt loan demand, if a 1.5 percentage point move in borrowing costs is enough to make a project unprofitable, it probably wouldn’t have gone forward in the first place. Businesses are a lot more adept at shouldering slightly higher borrowing costs than they get credit for, pun intended. 

Nightmare on Interest Rate Street

The Federal Reserve has now raised short-term interest rates eight times since December 2015. And the US economy has continued growing all the while. Yet that hasn’t prevented some observers from fearing the next rate hike will be the straw that finally breaks the camel’s back.

It is quite likely true that at some point, the Fed will overshoot and send this expansion toward its end. But the next rate hike, whether it occurs in December or not, seems unlikely to be this tipping point. Rate hikes generally kill expansions only if they invert the yield curve. Right now, there is a 0.91 percentage point gap between the effective fed-funds rate and the 10-year Treasury yield.^[i] If the Fed hiked tomorrow, that gap would shrink to 0.66 percentage points—smaller, but not inverted. Eventually, there will be a time to fear the Fed. But we don’t believe that time is here yet.